UK plans to use the leverage ratio for countercyclical and systemic capital buffers could throw the future of additional Tier 1 securities into doubt.

In early July, the Bank of England’s Financial Policy Committee (FPC) published a consultation paper on the role of the leverage ratio in the UK’s capital framework. The paper examines the interaction between risk-weighted capital and leverage ratios, and raises the possibility of moving to a more complex leverage ratio regime mirroring that of the risk-weighted framework.

Specifically, the paper mentions adding conservation, countercyclical (“time-varying”) and systemic (“supplementary”) buffers, as an add-on to the Basel III Pillar 2 minimum leverage ratio in the same way that these buffers have been incorporated into the risk-weighted framework. While the size of these potential buffers is not quantified, we suspect that they could add at least 100 to 150 basis points to the current 3% minimum leverage ratio requirement.

Fully loaded

The FPC paper asks to what extent additional Tier 1 (AT1) instruments should be used in meeting the leverage requirement. Given that the risk-weighted capital regime specifies that at least 75% of Tier 1 ratio must be met with core equity Tier 1 capital (CET1) and, to be consistent across the two approaches, the paper suggests at most 25% of the leverage ratio should be met by AT1 instruments. In fact, the paper questions whether AT1 should be used at all to meet the leverage requirement; AT1 conversion/write-down features are based on the risk-weighted framework.

According to the FPC: “It may be inappropriate to allow AT1 instruments, which effectively rely on the appropriate calculation of the risk-weighted ratio, towards meeting the leverage ratio, particularly when the trigger is low.”

Interestingly, for all of the major UK banks with the exception of Lloyds, a 7% fully loaded CET1 trigger ratio – the current UK regulatory requirement – is currently inconsistent with a 3% leverage ratio. In the most extreme case, Nationwide’s leverage ratio would fall to only 1.84% before its AT1 was triggered. Or to put it the other way round, Nationwide’s CET1 ratio would have to be kept above 12.94% (compared with a current ratio of 14.5%) to maintain a 3% leverage ratio. The implication of the above analysis is that on the basis of a fully loaded 7% CET1 trigger ratio, AT1 could be construed as ‘gone concern’ capital in a 3% leverage framework.

Competitive implications

If UK banks were limited or completely prohibited from using AT1 to meet their leverage ratio requirements, it could have some important implications. First, UK banks’ already-low profitability would be further pressurised and they would be put at a disadvantage relative to rivals in continental Europe, unless similar limitations were adopted on a pan-European basis. Second, what would happen to all outstanding AT1 paper issued by UK banks? Would these bonds be grandfathered for a period of time, possibly until their first call date or, if not, would there be regulatory par calls? If regulatory calls were invoked, this could have a significant negative impact on high cash price bonds.

Having examined several UK bank AT1 prospectuses, it is unclear to us whether a regulatory event clause would in fact be triggered because the terms and conditions of all the bonds only refer to the continued treatment of bonds as Tier 1 capital. From a risk-weighted perspective, AT1 instruments would still count as Tier 1, but from a leverage perspective this would not be the case.

While we must stress that this is only a consultation document, the direction of travel is clear with the UK regulator seemingly wanting to gold-plate the international leverage framework. We think there will be substantial opposition from the banking industry to some of the more extreme proposals. Nevertheless, we think UK banks will be forced to have a leverage ratio of more than 4%, rather than the current international norm of 3%.

We have some sympathy for the idea of making the leverage and risk-weighted frameworks consistent, but this will result in the leverage ratio losing its simplicity; one of its major advantages over the risk-weighted calculation. Finally, having permitted UK banks and building societies to issue AT1 to specifically meet leverage requirements, it would be difficult to reverse this decision and completely prohibit these instruments from being included in the leverage ratio. We suspect that further AT1 issuance will be put on hold by UK banks for now during the consultation period. If banks do issue AT1, prospectuses will include revised terms and conditions to incorporate the new regulatory risk to these instruments. 

Robert Montague is senior investment analyst at multi-asset credit investor ECM Asset Management, which is owned by Wells Fargo.

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