Basel Committee urged to rethink capital requirements

Bank leverage ratio requirements in Basel III could amplify risks in the financial system and fail the real economy, according to a group of industry associations.

Five lobby groups, including the Global Financial Markets Association (GFMA) and the International Swaps and Derivatives Association (ISDA) have written to the Basel Committee on Banking Supervision requesting changes to its proposed leverage ratio framework.

The letter forms part of the Basel Committee’s public consultation on leverage ratios in Basel III.

In it, the associations said they are concerned that the proposed framework’s methodologies would significantly overstate actual economic exposure of banks. They believe this form of measurement will result in the leverage ratio, rather than risk-based capital ratio, becoming the binding capital measure for a significantly number of banks.

While the risk-based capital measure takes into account how risky an asset is when assessing a bank’s capital requirements, the leverage ratio does not.

The associations believe this will require banks to hold much higher capital for their least risky assets such as cash and highly liquid government securities.

“This would create a perverse incentive to reduce such assets and the activities that generate such assets,” the letter said. “For example, the demand for high-quality sovereign debt would be reduced, thereby constricting liquidity, increasing volatility in the markets for such debt, and increasing the cost of government borrowing.”

If banks were to face a binding leverage ratio then they would also see a reduction in demand for low-risk debt, cutting lines of credit that are needed to support economic growth.

One example highlighted by the associations is the reverse repo market, where a typical agreement would require a 50 basis point spread simply to equal the cost of capital. By comparison, a similar transaction today would need a spread of 5 basis points. There is concern that this will not be economically viable for the banks, and as such most will reduce their participation in the securities financing market.

The associations have recommended a range of modifications to the Basel Committee, including excluding cash claims on central banks from its exposure measurements, as well as excluding several very low risk assets. By not including these assets in the leverage ratio, there would be less incentive for banks to push them out of their portfolios in favour of high-yield, high-risk instruments.

It said there should at least be partial exclusions on the above based on their relative levels of liquidity in order to ensure the securities financing market is able to continue functioning.

However, the associations said the Basel Committee should work to ensure that risk-based requirements are the key measure of a banks capital.

“The Committee should reinforce the longstanding principle that the risk- based requirements should be the binding measure and the leverage ratio the backstop measure for internationally active institutions subject to the Basel standards,” they added.