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 • … • … NZ • … • … Basel • … Australia • … • … NZ • … • …

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