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 www.imf.org/external/pubs/ft/wp/2000/wp00202.pdf
(How seriously are bloggers meant to reference material?)
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