Banks’ Off-Balance-Sheet Risks Come Under Basel Scrutiny

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Banks are set to face a broad international leverage limit that will catch off-balance sheet risks and prevent them from hiding their debt, according to the head of the Basel Committee on Banking Supervision.

The Basel group is seeking to put a ceiling on indebtedness that will prove robust no matter how complicated a bank’s business model, Stefan Ingves, its chairman, said in an interview.

“We want to catch leverage in a reasonable way, because one of the things that history has taught us is that when you look at episodes ex-post, when things fall apart, the conclusion is almost always that there was somehow too much leverage in the system and it was found out way too late,” said Ingves, who is also governor of Sweden’s central bank.

A quarter of large global banks would have failed to meet a draft version of the Basel leverage rule had the standard been in force at the end of last year, according to data published by the Basel committee on Sept. 25. Concerns that banks can reduce their capital requirements by simply changing how they measure the risk of losses on their assets have prompted calls from some supervisors for more reliance on leverage limits, on the grounds that they are harder for lenders to game.

Simple Bank

The group, which brings together regulators from 27-nations including the U.S., U.K. and China, is in “a good position” to complete work on the leverage ratio rule “towards the end of the year or sometime early next year,” Ingves said.

Under the committee’s timetable, banks will be expected to publish how well they measure up to the rule from Jan. 1, 2015, with the measure to become binding in 2018.

Regulators have said that moves by banks to boost profits, and in certain cases to hide the true state of their finances, by shifting activities off-balance sheet was one of the causes of the crisis that was unleashed in 2007.

“If you take a very simple bank, not really a lot of off-balance sheet items, well then it’s very straightforward how you do a leverage ratio,” Ingves said.

“Once you start looking into what’s off-balance sheet and how to deal with off-balance sheet activities gross or net, that’s when it gets more technical and more complicated, that’s where also the devil is in some of the details,” he said.

Lehman Collapse

Lehman Brothers Holdings Inc., whose collapse five years ago sparked worldwide market turmoil, used deals known as Repo 105s to remove assets from its books temporarily at the end of quarters, giving investors the impression that the firm had reduced leverage.

The core of the planned Basel rule is a requirement that banks hold capital equivalent to at least 3 percent of their assets, without any possibility to take into account the riskiness of a lender’s investments.

Leverage ratios differ from standard Basel capital requirements, which are measured as a ratio of banks’ equity against risk-weighted assets. The Basel group has said that the limit should be seen as a “backstop” to the risk sensitive rules.

“The level that was talked about” in 2010 “of 3 percent still stands,” Ingves said.

Recently, there has been “greater focus on more straightforward measures such as leverage,” Richard Reid, a research fellow for finance and regulation at the University of Dundee in Scotland, said in an e-mail. “But even here it would seem that there are significant opportunities for forbearance and mitigation.”

Risk Based

Supervisors are split over how much regulators should rely on leverage ratios as a tool to tame excessive risk-taking.

Advocates of the ratios include Andy Haldane, the Bank of England’s executive director for financial stability, and board members of the U.S. Federal Deposit Insurance Corp. Other regulators, including Bundesbank Vice President Sabine Lautenschlaeger, have warned that such measures shouldn’t be seen as a panacea, or as a replacement for risk-based capital rules.

“Tough leverage rules prevent the gaming that has made risk-based capital notorious, especially in the EU. But, it also creates strong incentives to hold as many high-risk assets as possible to game the leverage rules,” Karen Shaw Petrou, managing partner of Washington-based research firm Federal Financial Analytics Inc., said in an e-mail.

“There’s no simple, perfect answer, which is why effective supervision -- the weakest link of all -- is so essential,” she said.

Leverage Ratios

Part of the regulatory push for leverage ratios stems from concerns about potential gaming of capital requirements. The Basel committee said earlier this year that there are material differences in how much capital banks think is needed to guard against possible losses on their assets.

The Basel group will next month unveil some steps to address this as part of a draft overhaul of capital rules for assets that banks plan to trade, Ingves said.

“One issue there is disclosure -- how banks explain what kind of metrics they use when it comes to calculating risk-weighted assets,” Ingves said. “It’s absolutely clear that there are issues that need to be dealt with.”

Regulators in countries including the U.S., U.K. and Sweden have signaled their intention to force some of their banks to either meet the Basel rules ahead of schedule, or to adhere to leverage limits that are tougher than minimum international standards.

Morgan Stanley

JPMorgan Chase & Co. and Morgan Stanley will be among U.S. banks to face tougher leverage ratios than required under Basel.

The Basel committee sought views earlier this year on how the leverage ratio should apply to off-balance sheet activities such as derivatives trades and securities financing transactions.

“The key issue” in setting a leverage ratio “is really how you define assets,” Ingves said, speaking in Basel following a two-day meeting of the committee. “And the more complicated the bank, the more complicated it gets, then the more precise you have to be, in terms of particularly how you deal with off-balance sheet items,” he said.

Bank of England deputy governors Paul Tucker and Andrew Bailey told lawmakers in July that it was “right” for the U.K. to impose a 3 percent leverage ratio on banks immediately, five years earlier than plans agreed to by global regulators.

“There is a very clear view from our side that a 3 percent leverage ratio is a sensible minimum point to have institutions at, and those who are not at to have plans to get to,” Bailey told lawmakers in Parliament in London on July 2. “We are trying to establish what I would call a minimum baseline.”

Ingves also said that the committee would press ahead with reviewing how well nations have applied Basel capital rules.

The committee’s aim is that follow-up reviews of the EU and U.S. will be completed and published “at some point in the third quarter of 2014,” he said.

(Updates with analyst comment in 14th paragraph.)
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