Whose leverage ratio is it anyway?

Basel's capital backstop has been distorted out of shape by supervisory meddling

‘Backstop’ was a loaded term in the banking world long before it became Brexit’s bugbear. Post-crisis rules may have emphasised risk-based solvency requirements, but they also established the leverage ratio as a simple, sensible fallback to ward off attempts by banks to underestimate their exposures and artificially lower capital levels.

That was the theory, at least. In practice, the leverage ratio acts as the binding capital requirement for a host of banks. A Basel Committee on Banking Supervision study on the effects of post-crisis rules revealed the leverage ratio was the most constraining requirement at 59% of European banks and 25% of banks in the Americas. For a backstop, the leverage ratio is a little too front-and-centre for some firms.

Gold-plating of Basel rules by various national regulators also means there is not one universal leverage ratio but many, with the minimum requirement far higher for some banks than for others. US systemically important banks, for example, have to maintain a so-called ‘supplementary leverage ratio’ of 5% at the holding company level, nearly double the 3% minimum adopted by European authorities.

The splintering of Basel’s original vision of a uniform leverage ratio into multiple, conflicting iterations is now accelerating. US regulators have proposed a tweak to the SLR for custody banks that could eliminate around $200 billion of the exposure values used to calculate their ratios – but have not extended the carve-out to other lenders. Meanwhile in France, banks no longer have to count deposits held at state-backed institutions as part of their leverage exposures after a ruling by the EU’s General Court.

The Basel Committee itself is instigating a shake-up of the leverage ratio through its roll-out of the standardised approach for counterparty credit risk (SA-CCR). The new rule, intended to homogenise calculation of capital charges for counterparty exposures, also changes how derivatives are counted in the denominator of the leverage ratio.

As the SA-CCR has not yet been implemented in all Basel member jurisdictions, the sector-wide effect of the change cannot be quantified. But early indications suggest they will vary bank to bank. Nomura, for example, posted a 59-basis point improvement to its leverage ratio following adoption of the rule, whereas a trade association study of the likely effects on large US dealers estimated a deterioration to their aggregate ratio of 3bp.

The cumulative effect of all these global and regional modifications to the leverage ratio will be to undermine its original purpose as a universal capital backstop. Opportunities for regulatory arbitrage will flourish and policy-makers’ ability to compare bank solvency levels diminish. If this is the outcome, the question may be asked: just what is the leverage ratio for?

Correction, April 2 2019: This article was amended to correct the calibration of the supplementary leverage ratio. The minimum required ratio at the holding company level is 5% and at the insured depository level is 6%.