Leverage Ratio for Banks Can Rise as High as 5%, BIS Says

  • Increase from 3% should rein in risk-taking, research shows
  • Banks' models may understate asset risk, BIS report states

Global regulators have “considerable room” to raise the Basel III leverage ratio for banks as high as 5 percent from its current “test” level of 3 percent, according to research from the Bank for International Settlements.

The debt limit helps prevent damage to the financial system by containing the build-up of leverage and complementing other capital requirements intended to boost resilience, BIS researchers Ingo Fender and Ulf Lewrick said in the Basel-based institution’s quarterly review on Sunday. Quantitative analysis shows raising it as high as 5 percent would result in more stability without strangling credit supply, they said.

Raising the leverage ratio currently being tested by the Basel Committee on Banking Supervision to within a range of 4 percent to 5 percent “should help to constrain banks’ risk-taking earlier during financial booms, providing a consistent and more effective backstop to the risk-weighted capital requirements,” the researchers said.

The leverage ratio is designed to curb banks’ reliance on debt by setting a minimum standard for how much capital they must hold as a percentage of assets on their books, exposures due to derivatives and securities financing transactions and off-the-book risks. For most other regulatory requirements, such as the common equity Tier 1 ratio, assets are weighted for risk.

‘Room for Maneuver’

Some regulators have already pushed leverage ratios to 5 percent and beyond. The U.S. imposes a requirement of at least 5 percent on the biggest bank holding companies. Switzerland in October instructed UBS Group AG and Credit Suisse Group AG to hold capital equal to 5 percent of assets.

The Basel committee, which brings together regulators such as the U.S. Federal Reserve and the European Central Bank, plans to determine in the next two years where to set the minimum level, with the intention to set a mandatory standard as of Jan. 1, 2018.

The BIS researchers said their analysis “suggests considerable room for maneuver in terms of higher leverage-ratio calibrations, in particular for global systemically important banks, where additional capital requirements are likely to reduce the risk of systemic crises most.”

The unweighted approach is needed to counter inherent weaknesses of risk-assessment, which can be done with banks’ own internal models or with standardized rules, according to the BIS report.

‘Artificially Low’

“The models used to generate the risk weights may understate risk,” the researchers said. “That is, measured risks tend to become artificially compressed in times when credit spreads are tight, defaults are rare and volatility is low. In addition, models may provide incentives for ‘gaming,’ by making assumptions that are hard to verify and result in artificially low risk weights.”

Banks with higher risk weights tend to be more constrained by the risk-weighted capital requirements, while those with lower risk weights are more constrained by the leverage ratio, the researchers said. To constrain half of banks with the leverage ratio and half with risk-weighted rules, the ratio should be about 4.5 percent, they said.

Most banks already exceeded the test level at end-2014, the Basel committee said in March. In a representative sample the group is monitoring, large banks on average had a 5 percent leverage ratio, the world’s biggest banks had 4.9 percent and smaller banks 5.6 percent. Out of Basel’s 212-bank sample, 17 didn’t meet the 3 percent level.

Costs to the broader economy, mostly caused by banks’ charging higher interest rates for lending to compensate the additional capital costs, would be significantly lower than the benefits thanks to banks that are more stable and cause less damage when they collapse, the researchers say.

The results are in line with research published by the ECB researchers last month, who found that a binding leverage ratio would make European banks more stable if the levels aren’t set too high. The ECB’s Michael Grill, Jan Hannes Lang and Jonathan Smith said that benefits starts to fade when the leverage ratio reaches about 5 percent.

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