To keep banks from gaming rules designed to ensure they hold adequate, quality capital against the loans they make, international banking supervisors on Wednesday released details on a proposed 3 percent leverage ratio for banks worldwide. They said the more simple measure of leverage would prevent banks from building up excessive debt or risky assets, both of which might not show up in so-called “risk-based” capital ratios.
The Basel Committee on Banking Supervision, part of the Bank for International Settlements, said this new form of leverage ratio — which would be the same worldwide, despite differences in accounting standards — would “restrict the buildup of leverage in the banking sector to avoid destabilizing, deleveraging processes that can damage the broader financial system and the economy.” The committee also said it would be more transparent than other capital requirements, because banks would have to disclose the information in a common format.
The proposal comes as U.S. banking regulators debate over whether a 3 percent leverage ratio is high enough, and bankers argue that risk-based capital ratios are best for determining a bank’s overall leverage. In commenting on U.S. legislation that would set a similar leverage ratio domestically, law firm Davis Polk said in April that a leverage ratio is “too blunt an instrument for prudential financial regulation because it is not capable of distinguishing between risky and non-risky assets, and could result in two banks with vastly different risk profiles holding exactly the same amount of capital.”
A simple leverage ratio would force financial institutions to hold the same amount of quality capital against any loan they make, regardless of the riskiness of the loan. That contrasts with other capital ratios that assign a “risk weighting” to loans to require a larger capital cushion for riskier instruments. Although bankers say the measure could discourage low-risk lending activities, some regulators say banks have found it too easy to get around risk-based capital requirements.
Wednesday’s consultative document from the Basel Committee provided some details on the exact formula for the leverage ratio’s calculation. Banks would not be able to hide risky assets outside of their balance sheets, for one. The proposed ratio would also change how derivatives count toward leverage. For example, collateral received by a bank in connection with a derivatives contract would not be allowed to offset the leverage that the derivatives exposure represents. In addition, the leverage ratio’s asset measure would encompass such off-balance-sheet items as liquidity facilities for corporations and trade letters of credit.
The Terminating Bailouts for Taxpayer Fairness Act, introduced by Sens. Sherrod Brown, D-Ohio, and David Vitter, R-La., in April contains some of the same provisions as the newly released Basel formula and calls for the total elimination of risk-based capital rules. It also calls for total abandonment of Basel III.
Members of the Federal Reserve Board have publicly stated that a leverage ratio of 3 percent is insufficient to prevent taxpayer bailouts of banks. The Brown-Vitter bill would require banks to hold capital equal to 10 percent of their assets; systemically important banks would have to hold even more capital.
“The Basel III proposal belatedly introduces the concept of a leverage ratio but calls for it to be only 3 percent, an amount already shown to be insufficient to absorb sizable financial losses in a crisis,” said Thomas Hoenig, vice chairman, Federal Deposit Insurance Company, in an April speech in Basel, Switzerland. “It is wrong to suggest to the public that, with so little capital, these largest firms could survive without public support should they encounter any significant economic reversals.”
Hoenig has also suggested that U.S. regulators scrap the Basel III capital rules, which the U.S. has yet to adopt.
If the Basel proposal is instituted, banks would have to publicly disclose their leverage ratios starting January 1, 2015, assuming their country had adopted the Basel III framework. Disclosures would have to follow a common format, including a table that compares total accounting assets and leverage ratio exposures and a reconciliation of material differences between on-balance sheet exposures in the leverage ratio disclosure and total on-balance sheet assets in a bank’s financial statements.
The Basel Committee would make any adjustments to the ratio’s makeup by 2017, with an eye toward a January 2018 final implementation. The Basel Committee said it will undertake a study of the economic impacts of the leverage ratio before it is finalized.