Sunday, 19 January 2014

Decoding the Basel III regulations on the Leverage Ratio (Because God knows it requires decoding)*

Leverage can be understood as the “magnification of the rate of return (positive or negative) on a position or investment beyond the rate obtained by a direct investment of own funds in the cash market.”** In less tedious terms, we know banks lend using resources that do not really belong to it. Leverage ends up measuring the extent to which this is true. As a formula, it is the ratio of a bank’s assets to its capital-the assets being the loans and advances (the investment) the bank makes, and capital (to put it a tad inaccurately) being its own funds. But if lending other people’s money is the bank’s primary job (it is), why is high leverage such a big deal?
It wasn’t (I think), till the global financial crisis, when banks exhibited very high leverages. This meant that they were extremely vulnerable if their investments did not pay off- so many more of their creditors would have to be paid out of their own funds (or capital). Even the perceived fear of such an eventuality would then mean de-leveraging-borne out by the credit crunch that followed.  
Were our regulators completely blind to these risks, then? Not entirely. Banks were required to maintain a certain proportion of their risk-weighted assets as capital. The more risky their assets, higher the capital they had to maintain to protect against possible losses. However, the way that banks calculated the risks attached to their assets, was left to them. It wasn’t apparent to the regulators that banks might under-estimate the risks attached. To prevent the kind of skulduggery that did happen, Basel III has now come up with its recommendations on the Leverage ratio.
For the uninitiated (which if you are reading this post, you probably are), the “leverage ratio” is not the same as leverage. It is the exact inverse (because financial concepts were not murky enough already), i.e. it is the ratio of a bank’s capital to its assets. Basel tentatively fixes this at 3% (to be reported as the average of the monthly leverage ratios maintained over a quarter), but might make further changes in case a need is felt. Paid-in common shares of the bank, retained earnings, share premium account etc. qualifies as capital. The reason the regulation needs decoding is the way that “assets” (or as Basel puts it, the exposures) are to be treated when calculating the ratio. Essentially, these may fall into four categories-non derivative balance sheet exposures, derivatives, securities financial transactions and off-balance sheet exposures.
The treatment of non-derivative balance sheet exposures - simply the loans and advances made by the bank-is simple enough. If a bank has made provisions against certain non-performing or doubtful loans, it may deduct the same from the measure of loans it reports.  A gross measure of loans has to be reported, without netting for liabilities. This means that if a bank has loans of Rs. 10,000 and deposits of Rs. 2000, then its exposures are the Rs. 10,000, not the Rs.8000 difference between loans and deposits. Liabilities cannot be counted at all. For instance, a bank may have issued a bond (which counts as its liability) at a certain rate of interest. If the market rate of interest increases thereafter, the price of the bond falls. In accounting terms, banks make a profit. Basel III disallows profit on this account to be counted as part of capital or added to the measure of exposure.
The treatment for derivatives is a little more involved. Remember that derivatives refer to financial instruments which reference an underlying asset. This asset may be a real good (in the case of a commodity forward contract) or a financial instrument (e.g. credit default swaps or interest rate swaps). Take the example of an interest rate swap. Such a contract brings together two (counter-) parties who agree to exchange interest payments on a certain principal amount, a predetermined number of times, on pre-specified dates. The principal amount has actually no role to play, except serve as the base on which the interest payment is calculated. This may be for instance Rs. 1000, and is the notional value of the interest rate swap. One party to the swap agrees to pay the other a flexible interest rate on the 1000 rupees, the other a fixed interest rate-of say 10%. If at the time when the interest payments have to be exchanged, the flexible interest rate is 12%, the flexible interest rate payer is at a loss of Rs. 20 (120 he has to pay minus the 100 he receives). If the rate is 8%, the fixed interest payer loses (100 that she has to pay minus the 80 she receives from the counterparty).
Derivatives exposures of the bank have to be treated, both for the counter-party credit risk involved (i.e. the risk of the opposite party in the contract, reneging on its obligations), and the exposure to the underlying. To calculate the exposure to counterparty risk, banks need to account for the current market value of the contract (replacement cost), if they expect to benefit from the contract (i.e. if they are the flexible interest payer when the flexible interest rate is 8%). If they are set to lose, then the replacement cost is zero. However, this would only count for current exposure. To account for potential future exposure, banks have to add an amount equal to a certain fixed percentage of the notional value of the derivative (which like I said before, is the principal amount of Rs. 1000). Where the underlying is a credit exposure, (e.g. credit default swap- the buyer of the contract makes a regular payment to the seller in exchange for the promise that he will be reimbursed in case of a default on a loan she made to a third party) the notional amount referenced by the credit derivative counts as the bank’s exposure to the underlying asset. In the example of the credit default swap, this is the loan amount that the derivative insures.
Collateral received on derivatives, is not be not subtracted from the measure of the derivatives exposure, it also has to be added in separately as an exposure. This is because banks can possibly use the collateral so obtained to leverage themselves even more. The treatment of the cash variation margin as a “form of pre-settlement payment” is more benign. The cash variation margin is essentially the payment that one party makes to the other, in response to changes in the market for the underlying. In futures trading mediated through an exchange (known as the central counterparty), participants have to be submit an “initial margin” as good faith payment. Suppose this is Rs. 10 for each futures contract, actually worth Rs. 100 in the future (i.e. the two parties have agreed to trade the underlying good at this price, at a fixed time in the future). If A and B, the two parties, respectively bought and sold 50 such futures contracts, they both would have to post an initial margin of 500 with the exchange. Suppose also that the maintenance margin on each contract is Rs. 7. This means that if the initial margin deposited by either party, falls below this threshold, the concerned party will have to reimburse the exchange till the initial margin is met again. This reimbursement has to be in cash. As you may have guessed, this is the cash variation margin. Suppose during the course of a trading day, the futures price for the contract A and B traded, turns out to be lower at Rs.96. A, the buyer consequently makes a loss of Rs. 4 on each of the 50 contracts. If the total loss of Rs. 200 is deducted from the initial margin, the remaining balance is Rs. 300, lower than the maintenance margin of Rs. 350. A has to then step in to make up for the difference between the current balance and the initial margin. The Rs. 200 paid in this case, is the cash variation margin. Banks can subtract it from the measure of the replacement cost. Banks that have paid cash variation margin can subtract it from its exposure measure if it had been counted as one, on the balance sheet.
A last word with respect to derivatives- banks may also act as clearing members, wherein they interpose themselves between the client and the central counter-party (essentially the exchange where derivatives trade). In the scenario where they guarantee the performance of the derivatives contract to a party in case of default by the opposite party (either by the central-counterparty or the client), this exposure must count as if the bank had entered into the derivatives contract for its own sake.
Next, is a discussion on the securities financing transactions that banks may enter. Examples include repo transactions, wherein the “borrower” sells securities to the “lender” with the agreement to buy the same back, at a pre-specified time and (higher) price in the future. The securities sold are essentially a collateral for the cash loan made. This is a repo transaction if described from the point of view of the borrower, a reverse repo defined from the point of view of the lender. A similar transaction involves securities lending, where as the name suggests, securities are lent. Other securities or cash, serve as the collateral.
Where the bank enters into a securities transaction for its own sake, the gross assets (cash/security lent) serve as the measure of exposure. Additionally, banks must account for the counter-party credit risk. This is simply the difference between the amount lent and the value of the collateral already received. In case this difference is negative (i.e. the bank is a net borrower), banks must count this as zero. In cases where the bank enters into a transaction as an agent for a client, its exposure must only be on account of the counter-party credit risk. That’s because, as an agent, banks also explicitly offer indemnity (or protection in case of default by the counter-party). The last interesting regulation in this case, is the calling out of “sales accounting” by banks. This is a neat little trick banks employ to understate their leverage on balance sheets. Right before they have to disclose their balance sheets, banks enter into a repo transaction. In the first leg, they sell securities and account for the proceeds as a sale (and not as borrowing as they should). This cash is then used to draw down their debt temporarily. As soon as the balance sheet submission is done with, they buy back the securities (the second leg of the repo transaction), and things return to business-as-usual. The most infamous example of this practice, which Basel III explicitly prevents, was Lehman Brothers.
The last component that the current regulation deals with, are off-balance sheet exposures. These refer to components like bankers’ acceptance-which are short-term debt instruments issued by companies and guaranteed by banks. Or commitments to lend, that haven’t materialised as yet. Basel III requires these to be converted into credit equivalents by multiplying them with pre-determined factors. So for instance, standby letters of credit are to be treated as a credit exposure of an equivalent amount (a 100% conversion factor). The very dangerous securitisation exposures are to be treated the same way. Then there are other exposures where the conversion factor is lower. For revolving underwriting facilities-where a bank stands ready to lend in case the prospective borrower fails to raise funds in the euro-currency market, the conversion factor of 50%.
Most importantly, Basel III imposes heavy disclosure requirements on the banks. They must report a comparison table between their assets for accounting purposes and for the calculation of the leverage ratio, a breakdown of the components under the leverage ratio’s purview, details of the difference between balance sheet assets and on-balance sheet exposure component of leverage ratio exposures and reasons for the changes in the leverage ratios between reporting periods.
The interesting question is, have any countries used this measure? And to any success?
Canada reportedly serves as an example of one such country-which has used a ceiling on the assets-to-capital multiple (leverage, really) for many years. Though it plans to officially move to a Basel III regime for the leverage ratio, it currently places a limit of 20 on the leverage allowed. Banks may increase this to 23, if they are able to take prior approval of the regulator. In turn, this approval is contingent on the risk-based capital ratios exceeding certain targets, the absolute level of capital being above a threshold, ratio of risk-weighted assets to un-weighted total assets, adequacy of banks’ capital management policies (where the banks can prove compliance to the leverage ceiling and the risk based capital ratio, through the period, and not just at the time of reporting), no regulatory skirmishes for four consecutive quarters, and no risk concentrations. These have to maintained at least for two years after the bank has received the permission to increase its leverage beyond 20. Failure to meet the ceiling may lead to imposition of still stricter ceilings. The measure of capital is Tier 1 equity capital (in line with Basel III). Exposures include off-balance sheet exposures like letters of credit and guarantee, transaction and trade related contingencies, and sale and repurchase agreements, all of them taken at their notional value (100% credit conversion factor).
The United States of America requires banks to maintain a minimum leverage ratio of 4%. However, the denominator is just the organisation’s average total consolidated assets less deductions to tier 1 capital. That means off-balance sheet exposures are not counted as exposures. However, banks that use their internal models to attach risks to assets, are subjected to what the regulators call a minimum “supplementary leverage ratio” of 3%. This is quite close to Basel’s leverage ratio-i.e. the denominator includes both on and off-balance sheet exposures. UK also requires its major banks to maintain a leverage ratio of 3%, again taking into account all exposures (on and off-balance sheet). Maldives imposes a leverage capital ratio of 5% f, though its denominator only includes total assets. Efforts are on to design these for other countries-even those that do not have any banks with internal models for risk measurement. The argument in favour of that is the leverage ratio’s simplicity. Will you be surprised to know that I laughed really hard at that?

* Needless to say, you are a prat of the first order if you think this post (or any post on any blog for that matter) constitutes professional advice. So don't be a prat.

** See, "Measuring Off Balance Sheet Leverage", Peter Breuer, 2000. Available at
(How seriously are bloggers meant to reference material?)

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