Regulators struggle to conjure the right leverage ratio

Too low, and it has no effect; too high, and liquidity suffers. Time for flexibility?

Prudential regulators interpreted the financial crisis as the lethal combination of three factors: poor liquidity management, inaccurately measured and mispriced risks – especially in securitisation markets – and excessive leverage. The Basel III package of reforms is intended to address all of these.

The liquidity coverage ratio (LCR) and net stable funding ratio (NSFR) are designed to ensure good liquidity risk management. Rules governing risk measurement for capital ratios have been tightened considerably, especially for market risk and securitisation. And the leverage ratio, already a feature of the US regulatory landscape, has been introduced internationally as a risk-neutral capital backstop.

The principle of the reforms seems clear enough. The practice is anything but. Crucially, these three core changes interact with each other in ways that are difficult to predict exactly. The LCR requires banks to hold high-quality liquid assets (HQLAs) that are low risk – with correspondingly low returns – and can be sold during a funding squeeze. But the leverage ratio penalises HQLAs with a capital charge that ignores their low-risk nature. To offset the troublesome economics of this pincer movement, banks may be forced to herd into higher-risk, higher-return assets for the non-HQLA part of their portfolios.

Somewhere in between, there is a group of assets that could simply become uneconomical: they do not qualify for HQLA status, but nor do they generate returns to meet the hurdle posed by the leverage ratio if it is set too high. Unfortunately, some of these activities sit at the very heart of the financial markets: balance sheet intermediation, including fixed income market-making and repo financing. As Risk.net reported in September, US repo markets have become increasingly reliant on French banks that only need to comply with the leverage ratio once a quarter. No-one has yet presented a convincing alternative to banks as the cornerstone of high-volume transactional balance sheet provision, of the short-term rather than the millisecond variety.

Among regulators, the Bank of England (BoE) is arguably asking the most searching questions around the implications for financial market resilience. The BoE's July financial stability report sounded perhaps the strongest warning to date about the decline of financial market liquidity, and especially repo volumes in the UK: "The financial policy committee judges that these developments are of sufficient importance to financial stability and market functioning to warrant further domestic and international assessment of their causes and consequences."

The industry thinks it knows the answer: exempt the safest HQLAs from the leverage ratio to ensure banks can meet their liquidity management obligations without tying up too much of their balance sheet. For Basel III's strongest advocates in the regulatory world, though, this looks like a retrograde step. The BoE is seeking a compromise by exempting only central bank deposits from the leverage ratio. So far, this has been presented as a purely UK-specific measure, but the tone of the financial stability report makes it clear the BoE will also propose the idea at Basel.

International standard-setters are not generally fond of granting national supervisors broad scope for making local adjustments to the rules. Perhaps it is time to acknowledge, however, that Basel III is a vast, complex and untested framework. The BoE's leverage ratio plan may not be to everyone's taste, but those around the Basel table should at least welcome the principle of regulators having the flexibility to respond swiftly – not once a decade – if they feel the regulations are having demonstrable unintended or undesirable consequences.