PRIMER: leverage ratios

Author: Bozena Gulija | Published: 28 Aug 2018
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Regulation and risk management expert Bozena Gulija looks at how they are measured in the banking sector

What is leverage?

In simplified terms, leverage in finance refers to any use of borrowed sources for funding an enterprise in order to achieve an additional, multiplied effect for the owner. The leverage becomes higher as the proportion of external sources of financing increases compared to the owner's own investment. It can be measured in different ways, but the most common method is the debt-to-equity ratio. Depending on the relation between equity costs and borrowing costs, additional leverage – reflected in higher leverage indicators – can bring additional return on equity, but this opportunity is usually accompanied by increased risk.

In the banking sector, leverage ratios have historically been used by some national supervisors and the prevailing format for measuring leverage involved employing capital divided by assets, although there have been some exceptions (eg the asset-to-capital multiple in Canada).

The reasoning for choosing such a measure, which is contrary to the leverage definition logic and indicators used for real sector companies, is that it follows the same principle as the risk-based bank capital adequacy measure where the capital also appears in the ratio's numerator. Therefore, the higher a bank's leverage (and the related risk), the lower its leverage ratio. Compared to non-financial sectors, banking is by its very nature a highly leveraged industry as its core business is based on financial intermediation, transformation and risk management. However, it should be noted that in the 19th century, the average bank balance sheet leverage ratio in the US and in other developed economies was around 50%, a level that fell continuously until the 1940s. It has remained below the 10% mark since then.

An international standard for banks

One of the underlying causes behind the 2007 financial crisis is considered to be the problematic build-up of excessive leverage in the banking sector, which was not properly reflected in the risk-based ratio used as the key capital adequacy indicator at the time. Criticism with regard to risk-based ratios mainly focused on their complexity, over-reliance on external ratings, and dubious internal models used for regulatory purposes, while some statistical evidence even showed that leverage ratios provided a better prediction of a bank's failure during a crisis than risk-based ratios. On the other hand, it is difficult to disregard the inherent disadvantage of leverage ratios as they treat banks with the same leverage identically regardless of, for example, the riskiness of their loans.

The Basel Committee (BCBS) decided to make use of the complementary characteristics of both ratios, and for the first time introduced an international standard for leverage ratio in addition to the risk-sensitive capital adequacy ratio(s), as part of the ongoing Basel III reform. Its main objectives are to act as a backstop against unsustainable leverage accumulation and as a constraint against model risk and measurement errors.

The main difference between the leverage ratio and the risk-based ratio arises from the denominator

Some of the important strengths of the leverage ratio are simplicity and comparability, and the BCBS formula for calculating leverage ratios is very straightforward: the capital measure is divided by the exposure measure, with the minimum ratio is set at three percent. However, some adjustments, national discretion, accounting frameworks, as well as divergent policy objectives, have already revealed that national implementation has a potential for complexity.

The capital measure in the nominator is tier 1 capital – the same as defined for risk-based capital framework and applicable in accordance with transitional arrangements. In essence, it is the going-concern capital that includes the highest quality components of regulatory capital such as common equity, retained earnings, disclosed reserves and some capital-like instruments.

The main difference between the leverage ratio and the risk-based ratio arises from the denominator – in the risk-based ratio assets are risk-weighted, while in the leverage ratio they are not adjusted for risk. The exposure measure in the denominator of the Basel III leverage ratio includes both on-balance sheet and off-balance sheet (OBS) items. On-balance sheet items – except derivatives and securities financing transactions (SFTs) which are subject to separate treatments – are, in principle, included at their accounting value.

The BCBS expanded the leverage ratio beyond on-balance sheet leverage and included OBSs with similar underlying effect as on-balance sheet leverage (for example, credit and liquidity facilities/commitments and guarantees). In order to calculate their leverage exposure, credit conversion factors (CCFs) are applied (ie OBS item's nominal value is multiplied by the corresponding CCF). The CCFs are the same as those used for credit risk under the risk-based capital framework, subject to a floor of 10%. Although some elements for the leverage exposure calculation are borrowed from risk-based methodologies, they don't reflect risk (eg after applying CCFs, OBS exposures are subject to risk weights for the purpose of risk-based ratios, which is not the case with leverage ratios).

Initially the Basel Committee started with a monitoring phase, but from the beginning of 2018, the leverage ratio was scheduled to become a binding requirement for large internationally active banks. Additionally, two modifications, which should be implemented by 2022, came up as a result of the Basel III finalisation agreed in December 2017:

(1) the revised leverage exposure measure (eg changes to derivatives exposure calculation, updated treatment of some OBS items, national discretion for temporary exemption of central bank reserves from exposure); and

(2) the global systematically important bank (G-Sib) leverage ratio buffer (50% of risk-weighted higher-loss absorbency requirements).

Implementation and national developments

The Basel Committee monitors the implementation of Basel standards according to the agreed timelines, consistency and outcomes. The latest progress report on the adoption of the Basel III framework, updated at the end of March 2018, assessed implementation of the leverage ratio in 19 jurisdictions (if the EU member states are not observed on a solo basis).

Pursuant to the BCBS exposure definition from 2014, the leverage ratio is fully implemented in 14 jurisdictions. As for jurisdictions that are behind schedule, Australia and Indonesia plan to implement the leverage ratio using the 2017 revised exposure measure, Mexico and the EU have legislative processes in progress (with the UK having implemented its leverage ratio), while Japan has not started the implementation.

From the beginning of 2018, the leverage ratio was scheduled to become a binding requirement for large internationally active banks

Although currently under review, there are three types of leverage requirements in the US:

(a) the generally applicable leverage ratio of four percent of tier 1 capital to total on-balance sheet assets;

(b) the supplementary leverage ratio (SLR) compliant with the Basel III standard and applicable to banks subject to the advanced approaches rule (ie intended for large internationally active banks); and

(c) enhanced SLR (eSLR) for US G-Sibs which must maintain a leverage buffer greater than two percentage points above the minimum SLR requirement of three percent.

The EU introduced leverage ratios into its legislation as part of the Capital Requirements Regulation (CRR)/fourth Capital Requirements Directive (CRD IV), but it still isn't a binding Pillar 1 requirement. The risk reduction measures with the banking reform package proposed in November 2016 include the CRR II provisions for a capital requirement based on the leverage ratio: the legislative process is in its final stages. The leverage ratio has recently received additional publicity in the EU due to a ruling from the European Court of Justice in a dispute between French banks and the European Central Bank which, in a broader context, can be seen as a signal about possible ambiguities in the calculation and implementation of a simple ratio.

Looking ahead

Compared to the initial Basel III proposals which date back from 2010/2011, the minimum ratio percentage and the capital measure have remained basically the same, but some significant changes have been made to the exposure measure following monitoring and consultations with banks. The refinement of exposure calculations and the provision of flexibility to national jurisdictions have taken a toll on simplicity and comparability.

Finally, the actual impact of national implementations of the binding Pillar 1 leverage ratio requirement, and subsequently G-Sibs buffer, remains to be assessed in terms of its main goal of limiting excessive leverage, and its effect on the banking system and the economy. In that context, a trade-off between additional risk-taking and increased capital coverage, as well as complementary benefits and burdens due to simultaneous implementation of leverage and risk-based ratios, should be taken into account.