Basel III Framework: The Leverage Ratio

Reducing excess "leverage" in the banking sector is a key component of the Basel III capital standards. "Leverage" for these purposes means the ratio between a bank's non-risk-weighted assets and its capital. The ratio is intended to be a hard backstop against the risk-based capital requirements and is also designed to constrain excess leverage, which was common amongst many banks pre-crisis. Banks will be required to hold Tier 1 capital of at least 3% of their non-risk weighted assets but some of the stricter elements of the 2013 proposal have been relaxed.

When the Basel Committee on Banking Supervision (the "Basel Committee") published its consultative document Revised Basel III Leverage Ratio Framework and Disclosure Requirements in June 2013 (the "2013 Consultation"), it was met with substantial opposition, particularly from banks involved in the securities and derivatives markets. Most significantly, the 2013 Consultation did not permit the netting of securities finance transactions and did not allow collateral to reduce derivatives exposures. Some banks feared having to raise billions in extra capital to meet the proposed leverage limit. Having carried out a study of bank data to analyze the potential impact of the proposed reforms, the Basel Committee published an amended full text of the Basel III Leverage Ratio Framework and Disclosure Requirements on 12 January 2014 (the "2014 Revision"), which considerably modified the leverage ratio's exposure measure.

The Leverage Ratio

The leverage ratio is a separate, additional requirement from the binding Basel risk-based capital requirements, so is a supplemental non-risk-based "back-stop." It is defined as the capital measure (the numerator) divided by the exposure measure (the denominator). The capital measure is made up of Basel III Tier 1 capital. The minimum leverage ratio is currently set at 3%.

Thus the method of calculating the leverage ratio is:

The Basel Committee has indicated that it will continue to collect data during the leverage ratio's observation period (i.e. until 1 January 2017) to assess both the appropriateness of a minimum Tier 1 level at 3% over a full credit cycle and for different types of business models, and the impact of using Common Equity Tier 1 or total regulatory capital (Tier 1 +Tier 2) as the capital measure.

The leverage ratio defines exposures (the denominator) as the total of a bank's:

on-balance sheet assets, including on-balance sheet collateral for derivatives and securities finance transactions not included in items (ii)-(iii) below; derivative exposures, comprising underlying derivative contracts and counterparty credit risk ("CCR") exposures; securities finance transactions ("SFTs"), including repurchase agreements, reverse repurchase agreements and margin lending transactions; and other off-balance sheet exposures, such as commitments (including liquidity facilities), guarantees, direct credit substitutes and standby letters of credit. The specific treatment of each of these types of exposure is set out in the summary table at the end of this client publication.

The exposure measure under the 2013 Consultation did not generally permit recognition of the exposure-reducing effects of any credit risk mitigation techniques (for example, through guarantees, credit default swaps, collateral or netting of loans and deposits). The 2014 Revision made some concessions in this regard, for example, allowing cash variation margin to reduce exposures when certain conditions are met.

Criticisms of the 2013 Consultation

The main criticism of the 2013 Consultation was that its measures were over-zealous to the extent that they increased the leverage ratio...

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