26 February 2014

BCBS/Ingves: Banking on leverage

Banks are highly leveraged institutions that are in the business of facilitating leverage for others. Beyond a certain point, however, we know that too much leverage can be perilous. Why then do we persist with fractional reserve banking systems that produce, in the very financial institutions that are critical to the health and stability of our economic systems, what in any other industry would be seen as dangerously high levels of leverage? Because the provision of credit is essential to the efficient functioning of market-based economies.

To compensate for this risk, almost all governments have set up regulatory regimes with minimum requirements for bank capital, leverage, liquidity, funding and large exposures - as well as behavioural standards on governance, fitness and propriety, risk management, internal controls and audit. These requirements aim to ensure that the high leverage inherent in bank business models is carefully and prudently managed. Basel III is at the core of this framework for internationally active banks. And a minimum leverage ratio - that is, an absolute cap on bank leverage - is a key component of the Basel III package.

Capital adequacy requirements and minimum leverage ratios are often spoken about as if they are one and the same. While they are similar in many respects, they are ultimately different concepts, and achieve different things:

Capital adequacy ratios measure the extent to which a bank has sufficient capital relative to the risk of its business activities. They are based on a simple principle: that a bank that takes higher risks should have higher capital to compensate. Leverage ratios, on the other hand, measure the extent to which a bank has financed its assets with equity. It does not matter what those assets are, or what their risk characteristics. Leverage ratios effectively place a cap on borrowings as a multiple of a bank's equity.

One shortcoming of the Basel framework before the crisis that is now evident is that it relied solely on the risk-based ratio to establish minimum capital requirements. As a means of controlling leverage, this places a premium on making sure that risk weights are right. Unfortunately, whether we are talking about standardised risk weights set by regulators, or risk weights determined by banks' own internal models, they are ultimately based on a prediction of the likely future course of events. The Basel III leverage ratio provides that safety net.

When it comes to the recently announced agreement on the leverage ratio, it is important to remember that it is an agreement on how bank leverage ratios should be measured. A common complaint for many years has been the inability to compare leverage ratios across jurisdictions because of material differences in accounting standards. Our recent agreement marks the development of an internationally agreed leverage ratio that is largely independent of national differences in accounting standards.

In terms of traditional on-balance sheet banking assets (like loans and securities), nothing much has changed: an asset on the balance sheet is an exposure for leverage ratio purposes. We count them one for one; there is no risk weighting. Much of our focus has been directed at the treatment of exposures related to repos (more technically termed securities financing transactions or SFTs), derivatives, and off-balance sheet items like loan commitments. The key things the Committee decided were:

• We allowed a degree of netting of SFTs, but only where strict criteria were met (for example, same counterparty, same maturity date).
• We allowed variation margin to be netted against derivative exposures - but only where the margin is paid in cash.
• We kept a firm limitation on the extent to which credit derivatives can be netted.
• We determined that the most appropriate measure of exposure for off-balance sheet items would be their credit equivalent value.

Of course, while there is a rationale for each of these decisions, there are also arguments for an alternative approach. For example, each of these changes brings slightly more complexity into the leverage ratio framework. Nevertheless, the Committee eventually reached the view that, on balance, these modifications would improve the measurement of leverage without jeopardising the underlying intention that the leverage ratio remain a simple backstop.

We now have an internationally agreed measure of bank leverage, which is no small feat in itself. But that is not the end of the task. Only now that we have an agreed definition can the Committee begin to turn to the issue of calibration, and the relationship of the leverage ratio to the risk-based framework. But our basic goal has not changed: that is, the risk-based regime should be the binding constraint on most banks most of the time, supplemented by the leverage ratio as a backstop.

The leverage ratio, by placing an absolute cap on borrowings relative to a bank's capital, is an important component of the Basel III framework, and complements the risk-based capital adequacy regime. But neither of these parts of the framework stands alone: it is important to look at Basel III as a package of constraints that mutually reinforce prudent behaviour. Even though the leverage ratio has been designed as a backstop, it must be a meaningful backstop if it is to serve its intended purpose. Getting the calibration right is therefore a critical part of the Committee's remaining work on the post-crisis reforms.

Full speech

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