14 January 2014

Fitch: Dilution of Basel leverage ratio assists trading banks

The changes, involving reverse repos and derivatives, reduce the assets included in the calculation and make it easier for them to meet leverage ratio requirements, depending on the final rules adopted by national regulators.

Fitch still expects on- and off-balance sheet exposures to reduce as trading banks make progress in meeting leverage ratio requirements, particularly for European institutions, where this is a new regulatory constraint. If banks took on additional risks to take advantage of the revised rules, Fitch would take this into account in its rating analysis.

Global and universal trading banks should also be able to build capital and be in compliance with the leverage ratio by the 2018 deadline, especially with the relaxed definitions. It is likely many banks will accelerate their compliance with the minimum 3 per cent standard, since public disclosure starts in 2015 and banks will want to keep in line with their peers.

The changes are to the leverage ratio's denominator - the exposure measure. Several deal with derivatives, where the exposure can now be lowered by deducting cash variation margins, excluding exposures that would be double-counted in some central clearing processes and capping written credit derivatives exposures at the level of the maximum potential loss.

Allowing some bilateral netting for repos and reverse repos could ease pressure on the banks and the market. The US tri-party market fell 14 per cent in 2013, according to data from the Federal Reserve Bank of New York published last week, as interest rate rises and regulation influenced volumes. In Europe, despite its recent revival, the repo market is still below its June 2010 peak. Fitch believes reverse repo books and secured funding at trading banks are likely to reduce further, even with the relaxation of netting rules.

A standardised leverage ratio should help adjust for accounting differences. For example, US GAAP has offsetting rules for derivatives that result in exposures being reported net, rather than gross under IFRS. The revisions allowing some netting appear to be a compromise between the two standards. But the extent to which the US will adopt the Basel definitions when it finalises its supplementary leverage ratio remains unknown. The US supplementary leverage ratio requirement will be double the Basel minimum at 6 per cent for systemically important bank subsidiaries (5 per cent at consolidated holding company level). If the Basel III leverage ratio definitions are not applied consistently across banks globally, this could undermine the comparability and usefulness of this ratio.

There was also a relaxation of rules for off-balance sheet items. Instead of weighting loan commitments at 100 per cent, off-balance sheet exposures can be weighted according to the standardised approach with a 10 per cent floor. This introduces some type of risk-weighting in the leverage ratio.

The debate on appropriate capital levels on a risk-weighted and a non-risk based approach is likely to continue. Fitch expects global trading banks' balance sheets to continue to shift, and where and how business is booked to continue to evolve, as final rules emerge and they optimise their capital and liquidity.

Press release

© Fitch, Inc.