Capital Review - Leverage Ratio in the Capital Review

Leverage Ratio in the Capital Review FSO Committee Paper 29th August 2018 Presented by Matthew Brunton

How a Leverage Ratio fits in
Total Loss
Absorbing
Capital
Leverage
Ratio
Numerator (Capital
Instruments)
Denominator (Risk
Weights)
Capital Ratio
Capital
Buffers

What is a Leverage Ratio?

• A leverage ratio is a non-risked based capital ratio.
  Instead of risk-weighted assets, it uses gross exposure values.

Change in regulatory appetite internationally

• Historically, there was a reluctance to adopt non-risk
  based leverage ratio requirements.
• However, following the GFC regulators and the Basel
  Committee acknowledged shortfalls in the risk-based capital framework.
• The inclusion of leverage ratio requirements in Basel III
  is meant to address two of these shortfalls:
• The impact of deleveraging on a financial system, and
• The need for a ‘backstop’ to the risk-based framework.

Objective 1:
The impact of deleveraging

• This was to avoid and mitigate the impact of deleveraging that is
  often associated with preceding periods of high leverage and can be destabilising to broader financial systems.
• The deleveraging process can occur through the restriction of
  lending and credit growth, a ‘credit-crunch’, which can have damaging second-round effects on the financial system.
• It can also happen through the liquidation of bank assets,
  particularly securitized assets, which can expose banks to losses through changes in market prices.

Objective 2:
A ‘backstop’ to the risk-based framework

• Growing attention to the issue of regulatory arbitrage, with a number of
  research papers and the Basel Committee noting the incentives to ‘game’ internal models.
• A leverage ratio, as a gross-exposure based measure, is a blunt but
  effective backstop. Does not fall with gaming of risk-weights, unlike capital ratios. Ensures that a bank’s capital-to-exposure doesn’t fall below a certain point.
• Capital Review already addressing some of these concerns (dual reporting
  and output floor). Effectiveness of these depends on their final form.

Key considerations
1 – Interaction with capital ratios

• A potential cost is a loss of risk-sensitivity if banks focus on a leverage
  ratio rather than capital ratios.
• However, calibration of the leverage ratio can be done so that banks
  are closer to their minimum capital ratios than their minimum leverage ratios in normal periods. RBNZ s105

Key considerations
2 – International alignment

• Several bank submissions to earlier consultation paper highlighted a
  desire for alignment with international frameworks, particularly with APRA.
• Benefits of international alignment include administrative efficiencies
  (for foreign-owned banks) and greater understanding of NZ framework to external stakeholders.
• We propose the leverage ratio calculation is based on APRA
  methodology.
  Basel
• …
  Australia
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• …
  NZ
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• …
  Basel
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  Australia
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  NZ
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Key Considerations
3 – Interaction with markets

• A leverage ratio that follows an international
  methodology (in this case APRA’s) will allow for greater understanding to investors.
• It may undermine the capital ratio’s influence
  on the market, however evidence from the US suggest that this has only been observed for large complex banks during the GFC.
• Market participants can already easily access
  other leverage ratios and information not required by RBNZ. Profit and Earnings Balance Sheet information Regulatory Ratios Market Prices

Key Considerations
4 – Compliance costs

• There would be additional compliance costs from leverage ratio
  requirements.
• However, this would be lower under APRA rather than Basel
  methodology
• Same methodology as parent for IRB banks
• Simplified version of the Basel calculation for standardised banks

Overall benefits and costs

• Benefits seems relatively low
• Current changes in the Capital Review partially address the need for a
  backstop.
• However, leverage ratio requirements would align NZ with international
  standards.
• The costs also seem relatively low
• RBNZ doesn’t have a monopoly over market information and evidence
  suggests capital ratios are still better measurements.
• Requirements can be calibrated to reduce risk of losing risk-sensitivity.
• There may be additional compliance costs

Decision

• Financial Policy would like the Committee to agree that
  the Bank consults on including leverage ratio requirements (both disclosure and minimum) in the ‘Ratio Consultation Paper’.
• This will be presented as our preferred option of the
  three.
• A final minimum amount will be presented and decided
  by the Committee with the final capital ratio calibration.

Appendix:
Stylised impact of the Capital Review