Regulators square up to leverage ratio challenge

Bank supervisors are increasingly advocating the introduction of a gross leverage ratio as a restriction on the growth of assets relative to capital, but the biggest challenge will be to create an internationally consistent measure under diverse accounting standards.

Leverage ratios already exist in Canada and the US, setting a limit on the ratio of a bank's assets to capital, but the difference in the treatment of derivatives under US Generally Accepted Accounting Principles (Gaap) and International Financial Reporting Standards (IFRS) would make it misleading to apply the same ratio to IFRS balance sheets.

Under Gaap, derivatives should be represented at their net value, while IFRS deals with gross exposures, meaning the value of assets used to calculate the leverage ratio could be different depending on the accounting framework.

"US investors have applied the leverage ratio to European banks and been shocked at how low their own ratios are," said Simon Adamson, senior analyst at independent research firm CreditSights. "In some cases, it might well be that leverage is higher at European banks, but in a lot of cases it is primarily due to the different accounting treatment. If the leverage ratio is to be used internationally, there does need to be some work done on standardisation of definitions and accounting treatment."

But regulators remain committed to the idea of the leverage ratio as a supplement to Basel II's risk-based capital requirements. The UK Financial Services Authority has advocated the introduction of such a measure and the Basel Committee on Banking Supervision has said it will produce proposals by the end of 2009. "We need the risk-based measure to interact with a simple metric that can act as a floor and help contain the build-up of excessive leverage in the banking system, one of the key sources of the current crisis," said Nout Wellink, chairman of the Basel Committee, in a speech before the European Parliament's Committee on Economic and Monetary Affairs on March 30.

The Committee will need to address the accounting issue if the leverage ratio is to work effectively on an international basis. Some have suggested it should be calculated on a consistent basis without any attention to accounting standards. "If the Europeans use IFRS and Americans use US Gaap, the ratio becomes very distorted," said Hugo Bänziger, chief risk officer at Deutsche Bank. "My preference would be for a leverage ratio that is calculated outside of accounting rules, using the total balance sheet on a netted basis."

The Swiss Financial Market Supervisory Authority (Finma) is introducing a leverage ratio for its two largest banks, Credit Suisse and UBS, to constrain the growth of their balance sheets. The ratio, set at a minimum of 3% at the group level and 4% for individual institutions, will become binding in 2013. As Credit Suisse draws up its accounts under Gaap and UBS uses IFRS, the regulator has allowed UBS to make deductions to the value of its assets to take netting into account before calculating the leverage ratio. "For equal treatment, we had to reconcile IFRS to US Gaap," said Daniel Sigrist, head of large banking groups at Finma.

The Swiss authorities also took the controversial step of excluding domestic lending from the leverage ratio in an effort to pacify the two banks and the Swiss government, which initially opposed the move. "We primarily wanted to bring back the balance sheet exposures of the investment banks, so it was not about the Swiss domestic business," said Sigrist.

But market participants argue any move to introduce a leverage ratio internationally must ensure regulators cannot exclude their own domestic lending businesses. "If you're going to have a leverage ratio, you should include all assets, not just those outside your own country," said Adamson. "As there isn't yet a standard definition of the leverage ratio, countries can largely do what they want for whatever purposes they may need."

See also: Quant Congress Europe: Regulatory focus to switch to leverage