Leverage Ratio in Basel III

Sanjay Basu, NIBM,

October 2019
 Outline
• Definition of RBI leverage guidelines
• Problems with High Leverage.
• Business Implications of Leverage.
• Basel III revisions.
 RBI Guidelines
• Banks will have to maintain a Tier I leverage ratio
(Tier 1 Capital/Total exposure) of at least 4.5%,
between 1.4.2013 and 1.1.2017. The disclosure of the
leverage ratio has begun from 1.1.2015.
 Minimum LR reduced to 3.5% (4% for D-SIBs) in June 2019.
 The average of the month-end leverage ratio, over the previous
quarter, will have to be reported.
• All on balance sheet items will be part of exposure,
without collateral, netting or credit risk mitigants.
 RBI Leverage Ratio Guidelines
• The gross exposure to repo agreements should be
taken, without netting long and short positions with
the same counterparty.
• The replacement cost, plus add-on for PFE, will be
the measure of exposure for all derivatives, without
netting long and short positions with the same
counterparty.
• All off-balance sheet items attract a credit conversion
factor of 100%. Unconditionally cancellable
commitments attract a CCF of 10%.
 BIS 2017 Caveat
• Some transactions can distort exposure measures:
1. Securities Financing (i.e. repo) and derivative deals
with positively correlated PDs and LGDs.
 The value of collateral or recovery rate falls as credit quality
worsens, increasing EAD.
2. Collateral swap trades aimed to reduce exposure.
3. Transfer of items from on- to off balance sheet.
 Repo Agreements
• Leverage is achieved by lending a security, in return
for cash, using the cash to acquire another security,
which then, in turn, can be “repoed” again to raise
more cash.
• The assets under the control of the leveraged investor
are the sum of his equity, consisting of the value of
the original security, S, and his debt consisting of the
sum of cash obligations under each repo.
• L= [(S+(1-h)i S)/S]
Leverage – Origin and Implications
• Banks have higher leverage than corporates, because
they specialize in taking deposits to fund the asset
portfolio.
• Leverage may also shoot up, during good times, when
cheap funding is used for rapid asset growth.
• High leverage magnifies both profits and losses - a
small change in asset value may have a large impact
on equity.
• High leverage increases liquidity risk as dependence
on borrowed funds increases.
 Problems with High Leverage
• There is a funding liquidity risk, due to maturity
mismatch, even if all assets are default-risk free.
 Even if the bank invests only in G-secs, the maturity of assets
is likely to be much longer than maturity of liabilities, to
maximize NIM.
 With high leverage, a large fraction of the assets are funded by
outsider liabilities (deposits and bonds).
 The bank might not have enough liquid assets to pay back the
interest and principal, when these relatively short-term
liabilities mature. The pressure of liquidity outflow might be
too high for the bank.
 Problems with High Leverage
• There is market liquidity risk, even if all assets are
default-risk free.
 The market price of even G-secs will crash if the bank tries to
sell off a large portion at a short notice.
 This scenario is likely to arise if the bank comes under short-
term liquidity pressure, e.g. in repo markets.
 The goal of the Basel III leverage regulation is to prevent the
build up of outsider liabilities, to fund asset growth. As long as
the bank is supported more by core equity, the liquidity
pressure from the liability side and distress sales on the asset
side, will be lower.
 Business Implications for Banks
• Likely to control the explosive asset growth which
led to the global financial crisis.
• Banks with lower leverage ratios (higher leverage)
have to raise more Tier 1 capital, or reduce exposure,
or a combination of both.
 Likely to raise Cost of Capital, since Tier II Capital has to be
replaced with Tier 1 capital for adherence to the leverage ratio.
• Cost of term deposits and long-term bonds is likely to
fall if bank assets are no longer funded, as much as
before, by outsider liabilities.
 Business Implications for Banks
• All undrawn commitments need not be converted to
exposure. Banks conduct behavioural analysis to
study how much of the undrawn portion could be
utilized. High CCF will badly hurt the OBS business.
• Low default OBS guarantees, as in trade finance,
could be badly hit with high CCF.
 Only 947 defaults, out of 5.2. mn deals (2008-2010, ICC).
 The cost of capital and lending rates on relatively safe OBS
commitments will go up.
 Banks with stable and safe OBS commitments will reap no
capital benefits.
 Business Implications for Banks
• Likely to shift lending towards riskier sectors, if not
supplemented by Basel II style credit risk regulation.
 Issues similar to Basel I criticisms.
 If the same level of capital is to be held, regardless of risk
quality, better to lend to riskier sectors.
 Better banks have a bigger Tier I capital buffer, which gives
them high leverage ratios.
 When they expand their businesses using the excess capital, it
is better to focus on riskier assets, to increase return on capital.
 But they also have much more to lose and may invest in safer
assets.
 Business Implications for Banks
• Repo markets will suffer if netting is not allowed.
They would be illiquid, costlier and less efficient
because of higher capital charges.
 Yields on G-secs and corporate bonds might spike.
 Monetary policy transmission, through repo markets, may
suffer.
 Repo in riskier corporate bonds may be more popular.
• Counterparty credit risk, in derivative markets, would
increase if exchange of collateral is restricted.
 BIS 2014 Revisions
• Use of Basel II CCFs.
 CCF on undrawn commitments up to 1 year is 20%. Beyond 1
year, the CCF is 50%.
 CCF for LCs, acceptances and guarantees is 100%.
• Limited reduction of only replacement cost (and
exposure), by cash variation margins, for derivatives.
• Limited allowance of bilateral netting on derivatives.
• Allowance of bilateral netting, of cash and securities
from the same counterparty, for SFTs, provided the
settlement date and system are the same.
 BIS 2016 Revisions
• Provisions which reduce Tier I Capital should also be
deducted from exposure, for both on-balance sheet
items and OBS items with CCFs.
• Open repos (i.e. without any explicit end date) not
eligible for netting under Basel III.
• Collateral cannot affect exposure (RC) to derivatives.
• CCFs will follow the revised standardized approach
to credit risk.
• Higher leverage ratios for G-SIBs coming soon.
 BIS 2017 Revisions
• Additional Leverage Ratio buffer at 50% of capital
surcharge (1% - 3.5%) levied on G-SIBs.
• If a G-SIB has 2% capital surcharge, additional LR
buffer (with Tier 1 capital) is 1%.
• A G-SIB must meet both higher (i) capital standards
(including CCB and surcharge, as a ratio of risk-
weighted assets) and (ii) leverage ratio requirement.
• G-SIBs which fail to meet both constraints will face
restrictions on capital distribution policies.
 Pillar III Disclosure Requirements
• Disclosures with the same frequency as their financial
statements.
• Mandatory: Average of month-end leverage ratios
over a quarter (Basel II ratio) along with three end-of-
quarter figures: (i) Tier I Capital (ii) The Exposure
and (iii) The Leverage ratio.
 If there is a material difference between the average ratio and
the end-of-quarter value, banks must provide an item-by-item
description and explanation of the difference.
 Banks must explain periodic (i.e. quarter-to-quarter) material
changes in the leverage ratio.
 Supplementing the Leverage Ratio
• Indian banks with the highest leverage ratios have
higher Tier I capital, but also relatively more OBS
exposures than others.
• Only a small fraction of exposure is supported by Tier
I capital.
 Even banks with high leverage ratios are exposed to liquidity
risk, from sudden exercise of OBS commitments and maturity
structure of liabilities.
 There is a need for additional Liquidity Risk guidelines.
 Fast asset growth during booms, when Tier I Capital is
relatively cheap, can also lead to systemic risk.