Revisions to the leverage ratio will help trade finance, but could introduce the same kind of regulatory arbitrage as the risk-weighted Basel ratio.
The Basel Committee on Banking Supervision has always presented the leverage capital ratio as a ‘backstop’ for more sophisticated measures that rely on risk-weighting banks’ assets. If banks become too aggressive in their modelling of risk, the pure capital-to-assets ratio will put a floor under how much capital they must hold.
But the growing fear was that the leverage ratio itself would become the first constraint on bank balance sheets, overriding more risk-sensitive analyses. This could encourage banks to take larger risks to generate a higher return on capital with a smaller balance sheet. The leverage ratio is a blunt instrument for assessing risk, rather than just size.
The modifications to the leverage ratio announced in January 2014 go some way to assuage those fears. Banks will receive relief on their off-balance-sheet trade finance transactions. This makes good sense. Trade finance is of direct benefit to the real economy and this form of lending, backed by physical goods that customers have already agreed to buy, has very low loss rates.
More debatable are the measures to allow netting of securities-financing transactions such as repurchase agreements (repos), as well as permitting offsetting hedges of credit derivatives exposures. The motivation is obvious enough. Government bond repos – the most common form – are heavy on the leverage ratio and many banks had warned they would cut back repo desks. That would hit liquidity in sovereign bond markets, hardly a desirable outcome for the Basel Committee’s political masters. But securities financing deals have become increasingly bespoke in terms of structure, with collateral moving far beyond sovereign bonds. That makes it difficult to assess whether two deals can be genuinely netted out. And assessing whether credit risk is being effectively hedged through credit default swaps is no easier.
The critique of risk weights has always required a degree of judgement, which opens up the Basel ratio to regulatory arbitrage. Allowing netting and hedging into leverage ratio calculations will introduce some of the same challenges. If it is to create a true backstop – providing an appropriate capital floor without damaging the incentives for good risk management – the Basel Committee will need to keep a close eye on how the leverage ratio works in practice and stand ready to modify it again.
