Leverage Ratio Framework – Basel III
The Leverage Ratio Framework is a key part of our approach to making the banking system safer. It was developed in response to the global financial crisis, where we saw that banks had too much debt, both on their books and in less visible ways. This high level of debt, or leverage, was a major problem. Even banks that seemed to be doing well in managing risks were actually very vulnerable because of this high leverage.
When the crisis hit its peak, these banks had to quickly reduce their debt. This sudden reduction, or deleveraging, made things worse. It pushed down asset prices and created a vicious cycle of losses, reduced bank capital, and less credit available to the economy.
To prevent this from happening again, we introduced a new rule under Basel III. This rule is straightforward and clear. It doesn’t focus on the risk of assets but looks at the overall leverage of a bank. The idea is to limit how much debt banks can take on. This limit serves two main purposes. First, it stops banks from accumulating too much debt, which can lead to big problems for the entire financial system and the economy if things go wrong. Second, it acts as a safety net, backing up other rules that do focus on the risks of different assets.
The Basel III leverage ratio is a key financial metric. It’s calculated by dividing a bank’s capital by its total exposure, and this figure is shown as a percentage. Banks are required to maintain a minimum leverage ratio of 4%. This means their capital must be at least 4% of their total exposure. They need to report this ratio at the end of every quarter, but it’s important that they meet this requirement at all times, not just on reporting dates.
When we talk about the scope of this ratio, it follows the same rules as those used for calculating risk-based capital. This means that the same group of companies included in the risk-based calculations are also considered for the leverage ratio.
However, there’s a specific point about investments in other companies. If a bank invests in another company that isn’t included in these calculations, only the value of that investment is counted in the leverage ratio. This is different from including all the assets and risks of the company invested in. Also, if an investment is deducted from the bank’s core or additional capital (as outlined in a specific section of the Basel III rules), then it’s not included in the leverage ratio calculation. This helps in keeping the leverage ratio focused on the bank’s own exposure, not on the fluctuating values of its investments.
The capital used in the leverage ratio is what we call Tier 1 capital. This is the same type of capital considered in risk-based capital calculations. However, it’s adjusted according to specific rules and transitional arrangements. Essentially, the Tier 1 capital we look at for the leverage ratio is the same as what’s used in risk-based assessments at any given time, but with certain modifications as required by regulations.
When calculating the leverage ratio, the exposure measure is a crucial component. This measure is generally based on the accounting value of different types of exposures, with some specific rules:
For on-balance sheet, non-derivative exposures, we include them in the measure after adjusting for any specific provisions or valuation adjustments. However, we don’t allow the netting of loans and deposits.
We don’t consider any physical or financial collateral, guarantees, or other credit risk mitigation techniques to reduce the exposure measure, unless specified otherwise.
The total exposure measure is the sum of on-balance sheet exposures, derivative exposures, securities financing transaction (SFT) exposures, and off-balance sheet items.
For on-balance sheet exposures, all balance sheet assets are included, except for certain derivative and SFT assets covered in other sections. If an asset is deducted from Tier 1 capital, it can also be deducted from the exposure measure. However, liability items are not deducted from this measure.
Derivative exposures are a bit more complex. They involve exposures from the underlying contract and counterparty credit risk. These are calculated using the replacement cost for current exposure plus an add-on for potential future exposure. If there’s an eligible bilateral netting contract, a different calculation method is used.
Collateral related to derivative contracts doesn’t reduce the leverage inherent in a bank’s derivatives position. So, when calculating exposure, collateral received shouldn’t be netted against derivative exposures. Similarly, if a bank provides collateral that reduces the value of its balance sheet assets, it should increase its exposure measure by the amount of this collateral.