Reserving judgement: the BoE’s divisive leverage ratio plan

Central bank reserves exemption may squeeze interbank liquidity, raise capital requirements

It all sounded so easy. Amid growing industry complaints about rising capital requirements, the Bank of England (BoE) decided to pull a rabbit out of the hat, and exempt central bank reserves from the leverage ratio, offering an estimated £11 billion ($13.4 billion) capital saving for the seven UK banks that are subject to the rules. The argument was that charging capital for money parked at a central bank would deter the industry from using central bank liquidity facilities, potentially increasing systemic risk and hampering monetary policy. Who could disagree with that?

But this simple plan might turn out to be a lot more complicated than it first appeared. The central bank's stance puts it at odds with other jurisdictions, such as the US, that are planning to implement the full hair-shirt version of the ratio – or it could trigger a new round of horse-trading as the Basel Committee on Banking Supervision hurries to lock down the last few details of a rule that was agreed in principle in January 2014.

"I think the Bank of England will get quite a lot of buy-in around the Basel Committee table, but the people who will agree with them will not necessarily have as narrow a definition of ultra-safe assets as the BoE would like; so if one country suggests exempting one type of ultra-safe assets, it could reopen the whole debate," says Paul Sharma, co-head of financial industry advisory at consultancy Alvarez & Marsal in London and former deputy head of the UK's Prudential Regulation Authority (PRA).

George Kaufman, co-chair of the US Shadow Financial Regulatory Committee and a consultant to the Federal Reserve Bank of Chicago, provides a taste of the likely US response to the idea.

"It smells like another attempt to lower required minimum regulatory capital ratios by arguing that bank deposits at central banks are always immediately at par and thus riskless and do not require any equity protection. Risk-adjusted capital requirements encourage this kind of thinking," says Kaufman.

The BoE has strong views of its own. In its July financial stability report, the BoE's Financial Policy Committee (FPC) presented what seemed a straightforward set of arguments in favour of exempting commercial bank reserves held at the central bank from the leverage ratio, which requires a bank to hold equity capital equal to some proportion of its exposures. The international baseline is 3%, and the Basel Committee is still discussing how much of a buffer to add to this for global systemically important banks (G-Sibs).

It smells like another attempt to lower required minimum regulatory capital ratios
George Kaufman, US Shadow Financial Regulatory Committee

The BoE's plan is to exclude reserves from the ratio denominator, provided they have notional maturities of no more than three months. The status quo would see capital requirements ticking up as banks placed more cash on reserve – a potentially pro-cyclical measure, the FPC argues.

"In circumstances where central bank balance sheets expand (for example, through increased use of liquidity facilities), regulatory leverage requirements can effectively tighten. Any increase in the supply of reserves must be held by banks in aggregate. Other things equal, therefore, leverage exposure measures would increase and leverage ratios would fall," the report notes.

If the exemption were not introduced, the BoE estimates that every £100 billion increase in the Bank of England's balance sheet would lead to a 10 basis point rise in the aggregate leverage ratio requirement for the major UK banks. Hence the leverage ratio could create a disincentive for banks to make use of central bank liquidity facilities in the first place.

Exempting central bank reserves from the leverage ratio could also be helpful where the central bank purchases assets outright from bank balance sheets, such as through quantitative easing (QE). In theory, the BoE is targeting institutional investors with its long-dated QE programme – its research suggests banks held only 4% of the stock of gilts at the end of 2008, mostly at the short end of the curve.

The banks would therefore act as intermediaries selling long-dated gilts to the BoE on behalf of clients and transmitting the proceeds to those clients. But pension funds or insurance companies tend to recycle the sale proceeds by increasing wholesale deposits at the banks. A study on regulatory change and monetary policy by the Basel Committee on the Global Financial System (CGFS) in May 2015 found that: "Outright asset purchases will – at least initially – tend to expand bank balance sheets unless the purchased assets are all sourced directly from banks, in which case the rise in central bank reserves on bank balance sheets would be completely offset by the decline in purchased assets."

BoE data shows banks have significantly increased their own holdings of gilts since the start of QE (see figure 1), suggesting they may have become more direct beneficiaries of QE bond buying. Even then, however, the leverage ratio exemption could still be useful. Central bank reserves pay the bank rate – currently 0.25% – so a zero leverage ratio requirement would provide an incentive to forgo the extra yield that might be on offer on QE-eligible bonds held by the banks.

That would be especially true for long-dated bonds that carry higher yields. Just weeks after the UK's vote to leave the European Union on June 23, the BoE's resumed QE programme stumbled when an attempt to buy £1.17 billion in bonds dated 15 years or above fell short by £52 million.

"If banks hold central bank deposits yielding almost zero, sometimes on quite a big proportion of their capital, monetary policy would not be very effective if banks have to get their return on equity by earning much more on the rest of their asset base. If the policy objective is to decrease the cost of lending, that may not happen if banks need to apply so much capital against central bank deposits," says Jouni Aaltonen, a London-based director in the prudential regulation division of the Association for Financial Markets in Europe (Afme).

By the time the QE purchase had fallen short on August 9, the BoE had already decided to act on its own recommendation. At its meeting on July 25, the FPC formally requested that the PRA should consider "allowing firms to exclude from the calculation of the total exposure measure those assets constituting claims on central banks".

The PRA then offered three waivers by consent from parts of the EU Capital Requirements Regulation (CRR) that will allow banks to benefit from the leverage ratio exemption. The seven systemic banks to which the PRA has applied the leverage ratio since January 2016 were apparently encouraged in the strongest possible terms by the BoE to request the waivers, and an updated list published in September shows they have all done so. The FPC estimates the exemption would cut the total amount of capital the affected banks need to meet the leverage ratio to £339 billion, from £350 billion.

Front-running Basel

Part of the reason for the FPC's decision was the perceived risk of heightened market volatility following the Brexit vote, making this a UK-specific move that does not have immediate international implications. The BoE decided to extend its sterling indexed long-term repo operations from June until the end of September to provide liquidity insurance to the banking sector in the wake of the referendum. The FPC noted there could be further expansion of the BoE balance sheet in the future, depending on decisions by the monetary policy committee.

"Banks can take reserves out of the central bank and put them to use elsewhere, but cash cannot always be deployed quickly in difficult economic times. The other side of the equation is that in stressed conditions, asset managers tend to liquidate some of their riskier assets and park cash with the banks that would typically deposit those very short-term excess funds with the central bank. If they are bound by the leverage ratio and don't have capital to put against central bank reserves, they may even have to stop taking in wholesale deposits," says Aaltonen.

That problem would be especially marked for banks with large custodian businesses. In fact, the July financial stability report notes there were already signs that the introduction of leverage ratio reporting in 2013 had begun to change the attitude of banks toward wholesale deposits.

Banks can take reserves out of the central bank and put them to use elsewhere, but cash cannot always be deployed quickly in difficult economic times
Jouni Aaltonen, Afme

"Evidence from brokered wholesale deposit markets suggests that UK banks typically reduce their presence close to reporting dates for leverage ratios, reflected in sharp falls in the rates offered," the report says.

The other aspect of the decision, however, is that the PRA has effectively front-run both the Basel Committee and the EU in its implementation of the leverage ratio. The Basel Committee is next due to meet on November 28–29, and the final standards for the leverage ratio are likely to be discussed at that meeting, before coming into force in 2018. The EU CRR – which implements parts of Basel III – only contains reporting requirements for the leverage ratio. The European Commission (EC) is due to produce draft final rules later this year to begin enforcing the ratio, following an advisory report from the European Banking Authority (EBA) in August.

By contrast, the PRA implemented the leverage ratio for its largest banks in full from January 2016. This leaves the UK regulator free to adjust the ratio as it sees fit until Basel and Brussels finalise their rules. The July 2016 financial stability report makes it clear that the BoE will feed its own experience of operating the leverage ratio into the Basel Committee discussions.

"The FPC encourages the Basel Committee to review carefully any possible unintended effects of forthcoming leverage ratio standards on the ability of the banking system to cushion shocks and to draw on central bank liquidity facilities," the report states.

Thin end of the wedge

If the UK proposes the central bank reserves exemption to the Basel Committee, however, it could easily be sucked into the wider controversy about the treatment of liquid assets in the leverage ratio. Industry bodies have long complained that the risk-insensitive capital measure clashes with the Basel liquidity coverage ratio (LCR), which requires banks to hold enough high-quality liquid assets (HQLAs) to meet 30 days of stressed outflows without fresh funding. This produces a large portfolio of low-yielding assets and also pushes up the exposure measure of the leverage ratio.

Data on G-Sibs compiled by the Financial Stability Board (FSB) for a report to the G20 heads of government in August 2016 shows the decrease in trading assets since 2006 has been almost entirely offset by an increase in non-trading securities (see figure 2). The FSB believes this rise is largely accounted for by greater holdings of ultra-high-grade bonds to meet HQLA requirements under the LCR.

In a joint response to the original June 2013 Basel leverage ratio proposal, Afme and seven other industry associations called for all Level 1 HQLAs – the most liquid assets – to be exempt from the leverage ratio exposure measure, including not just central bank reserves, but also the most highly-rated sovereign bonds. According to the minutes of the Bank of England's sterling money market liaison committee (MMLC) meeting in July 2016, some participants resurrected that request, suggesting "exclusion from the exposures measure should be extended to a wider basket of HQLA, such as gilts".

"With something that requires a lot of capital for any asset regardless of its quality, there is always then a demand to exempt ultra-safe assets – that discussion has been raging throughout the life of the leverage ratio," says Sharma at Alvarez & Marsal.

The FPC attempted to pre-empt this pressure by imposing strict conditions on the exemption in the UK. Not only would it apply purely to central bank reserves, but banks would have to show these reserves were matched by liabilities in the same currency, with equal or longer maturities than the central bank deposits.

"[The FPC] judged there to be no direct benefit to funding reserve holdings with capital: central bank reserves were a unique asset class because they were the ultimate settlement asset; and, if matched by liabilities in the same currency and of identical or longer maturity, they typically did not represent an exposure to risk," the FPC says in the record of its meeting. But this argument may not be enough to convince everyone.

"[These] conditions do not seem to align with the overall philosophy of the leverage ratio. The leverage ratio is all about not having too big a balance sheet, but it seems you could really be netting apples with pears in this case. I would be very surprised if it were to be accepted at the Basel Committee level, particularly as they have not had the chance to assess potential implications for it," says Hubert Justal, a London-based director in the risk and regulation team at Deloitte.

Neither the Basel Committee's most recent paper on the leverage ratio, in April 2016, nor the EBA's report in August mentioned the possibility of exempting central bank reserves. The idea is also absent from a draft EC proposal, seen by Risk.net, to follow up responses to its September 2015 call for evidence on the impact of regulation.

US regulators in particular have been extremely critical of any attempt to introduce what they perceive to be risk-sensitive measures into the leverage ratio. In an April opinion piece for Risk.net, the vice-chair of the Federal Deposit Insurance Corporation, Thomas Hoenig, argued the risk-weighted capital framework "has never worked to protect the industry or the public from even reasonable downside risk of banking".

Capital hike

To forestall this kind of criticism, the FPC makes clear in its statement that the exclusion of central bank reserves from the exposure measure will not be allowed to "mechanically reduce the nominal amount of capital required to meet the leverage ratio standard". To avoid this situation, the BoE is proposing "to recalibrate the UK leverage ratio standard to offset this impact" during a wider review of the ratio in 2017, and "in the light of the finalised international standard". In other words, the total burden would remain the same, with any relief for central bank reserves being offset by an increase in capital elsewhere.

The FPC statement outlines four ways in which this "grossing up" of the leverage ratio might be achieved. These would be to add to the core (3%) leverage ratio requirement; to add to the 0.35-times scalar the BoE has created to build a leverage ratio buffer for systemic banks; to add to both these requirements; or to create an entirely separate buffer. The only initial conclusion the FPC drew was that "it was important to maintain the proportionate relationship between the leverage and risk-weighted regimes".

This raises a number of questions for banks, not least whether the recalibration would be applied on average for the sector as a whole – which could effectively impose a capital penalty on banks that had made less use of central bank liquidity than average.

Monsur Hussain

"Reading through the minutes, it feels like the FPC was grappling with that question: do we want a system-wide overall increase, independent of how central bank reserves were held? There were concerns expressed by the FPC that grossing up the leverage ratio could be perceived as a tightening of the total capital requirements for banks," says Monsur Hussain, a senior director for regulatory policy in the financial institutions team of Fitch Ratings in London.

Moreover, the FPC statement specifies that it will ask the UK Treasury to change the relevant statute so the leverage ratio exemption "can be put in place on a permanent basis." This would seem to imply that any recalibration of the leverage ratio would also be permanent. And yet, the massive scale of central bank liquidity interventions including QE is intended to be only temporary, with central bank balance sheets expected to shrink when market conditions eventually return to normal.

"The danger at the Basel Committee is that the politics of recalibrating would be tough. The danger for the banks is that the BoE recalibrates on the basis of the offset that is needed because banks are holding unusually high central bank reserves at the moment, and then in a few years' time reserves reduce to normal levels and banks are stuck with the recalibration. The whole thing would end up demanding more capital net on average than previously," says Alvarez & Marsal's Sharma.

Market impact

The FPC minutes note that: "For the vast majority of firms, based on their current balance sheets, the amount of capital required to meet leverage ratio standards was lower than that required to meet risk-weighted standards." In other words, the leverage ratio is not currently a binding constraint in the UK, even when central bank reserves are included in the exposure measure.

That has left banks wondering whether the immediate benefits of exempting central bank reserves could be outweighed by the ultimate costs of recalibrating the leverage ratio.

"That would clearly incentivise banks to have larger pools at the central bank, not to do high-quality repos and provide short-term wholesale finance activities – central banks would become the lender of all resort, and the rest of the balance sheet would be more in the high-yield market because without significant repricing there is no incentive to make markets in corporate bonds and government bonds or to engage in clearing activities because the yields are so minimal," says Afme's Aaltonen.

In theory, central bank reserves are less attractive assets than high-grade bonds, because they cannot be used for other activities such as repo collateral. Even so, G-Sibs already use central bank deposits to fulfil 39% of their HQLA holdings, according to the Basel Committee's September 2016 Basel III monitoring report.

The FPC itself acknowledges the risk that grossing-up "could mean a tightening in financial conditions at the margin, particularly for low-risk assets like prime mortgage lending and repo activity. This could reduce market liquidity in core financial markets and was a concern in particular to those members who put weight on this consequence of the leverage ratio framework more broadly."

The July financial stability report sets the central bank reserves exemption in the context of two other changes to the leverage ratio that the BoE is urging at Basel. One is the netting of client margin against derivatives exposures for cleared derivatives, which would remove a potential disincentive for banks to offer client clearing services. The other is the netting of cash receivables and payables on securities transactions awaiting settlement, which would remove a potential disincentive for market-making activities.

Some US regulators have voiced strong opposition to netting client margin in the leverage exposure measure. By contrast, the leaked EC draft on its review of CRR suggests the EU will introduce this modification regardless of the outcome of Basel Committee discussions. Meanwhile, the Basel Committee included some impact study data on transactions pending settlement in its September monitoring report, without drawing any conclusions on their treatment under the leverage ratio.

The FPC concluded these two amendments were less urgent than the exemption for central bank deposits, and therefore decided to await the outcome of the Basel discussions. Even if the BoE fails to secure either of these modifications, it has repeatedly made a separate argument as to why the leverage ratio should not disincentivise low-risk, low-return activities. The FPC meeting record was only the latest in a series of BoE statements emphasising that "the leverage ratio framework [should] apply only at a consolidated level, not at the level of individual activities".

This intention, however, seems to cut across the normal capital management practices of most banks, which examine the capital consumption and return rates of individual business lines in order to make strategic decisions. Fitch's Hussain suggests the FPC's comment that the PRA will "monitor [the] behaviour of firms" could signal a more hands-on approach.

"It remains to be seen, when they visit as part of the supervisory review and evaluation process, whether the regulator would want to see evidence of how the banks are managing their leverage ratio on a consolidated basis without prejudicing individual business and product lines. Regulators will monitor how banks make use of this waiver, with the FPC observing financial market or pricing volatilities as a result of this change," says Hussain.

Funding costs up

In addition to a potential repricing impact on the asset side, there are also implications for bank liabilities. A meeting of the Bank of England's sterling risk-free reference rates working group in August noted that an exemption for central bank reserves would drive up competition between banks for wholesale deposits. This could lead to higher sterling overnight index average (Sonia) and repo rates.

Participants at both the MMLC and the BoE's securities lending and repo committee also raised questions about what liabilities would be eligible to back the central bank reserves in order to qualify for the exemption. If the matching criteria extended only to customer deposits rather than secured funding sources such as repo, the MMLC warned of a "possible bifurcation between unsecured cash and repo trades". That would exacerbate existing industry concerns about the asymmetric treatment of repo funding in the net stable funding ratio (NSFR).

"There is nothing now to indicate that repo might be eligible, and the trend has in any case been toward shorter-term repos – overnight or a week at most – because the increasing demands for HQLA mean banks would rather keep their assets rotating. But the BoE has been championing the development of term risk-free secured rates, so maybe if you get more official recognition of that, then repo could be used for the offset," says Alex McDonald, chief executive of the Wholesale Markets Brokers' Association (WMBA) in London.

He is more neutral on the market impact of the proposed exemption overall, but only because the interbank market is functioning in a very constrained fashion already. McDonald characterises the unsecured market as essentially two separate activities: one comprising the clearing banks taking in client funds while seeking to minimise their balance sheet for leverage ratio purposes, and a second consisting of mostly smaller firms meeting short-term borrowing needs.

The market is just about clearing, but there is not really much that one could characterise as trading going on; it is two discrete sets of counterparties entering the market at different points of the day
Alex McDonald, WMBA

"The market is just about clearing, but there is not really much that one could characterise as trading going on; it is two discrete sets of counterparties entering the market at different points of the day. Theoretically, the BoE would love to build more of a liquid secondary market for short-end money, but that still feels very far away, and the reliance on central banks as recyclers of liquidity seems ever greater," says McDonald.

Indeed, one criticism of the proposed exemption is that, in making central bank liquidity facilities more attractive from a capital perspective, the long-term goal of improving private market liquidity to wean banks off extraordinary monetary policies could be undermined. That could include the process of unwinding QE by selling central bank bond holdings back into the market. If banks bought those bonds with existing central bank reserves, the leverage ratio exemption would increase the relative capital cost of buying the bonds – although banks would be free to use other funding sources instead.

"It is difficult to see at this stage how that would play out, and what would be the capacity of the system to reabsorb those QE securities," says Afme's Aaltonen.

Alternative approaches

At Alvarez & Marsal, Sharma says the debate echoes similar arguments over the LCR and the NSFR: should banks manage their own liquidity tail risks, or should central banks be expected to step in with extraordinary liquidity facilities whenever market conditions deteriorate?

"What the BoE is doing would be more palatable to others around the Basel table if it said these are unusual times – while central banks are taking special measures, we are going to make this change to the leverage ratio, but once all that is finished, we will go back to the leverage ratio without exempting central bank reserves. In other words, to say this is a temporary measure to be deployed only in atypical circumstances," he notes.

The idea of a purely temporary exemption for central bank reserves would also make the proposal more practical for those central banks that still use mandatory reserve requirements as a tool for system liquidity management in normal market conditions (see box: Mandatory reserves dilemma).

There may equally be a less complex solution to banks engaging in severe short-term balance-sheet management just ahead of quarterly leverage ratio reporting dates, which was mentioned in the July financial stability report as one of the possible negative consequences of the leverage ratio. The US has already imposed daily leverage ratio reporting, and the UK will introduce daily averaging from the start of 2017.

"If you are trying to get around the issue of banks simply closing down in the days before quarter-end, we would suppose that to some extent, the problem will go away with daily average reporting," says the WMBA's McDonald.

This will not resolve the BoE's primary concern, however, which is that the banking sector should accommodate the increase in reserves generated by extraordinary monetary policies. It will be for other members of the Basel Committee to judge the wisdom of subjugating the development of prudential regulation to the priorities of monetary policy.

 

Mandatory reserves dilemma

The Bank of England (BoE) has emphasised that the Financial Policy Committee's (FPC's) decision to exclude central bank reserves from the exposure measure of the leverage ratio was a domestic measure for the UK that fits with the UK's monetary policy framework. In the July 2016 financial stability report, however, the FPC noted that it was feeding its views into international discussions at the Basel Committee on Banking Supervision.

QE dominates the formation of central bank reserves in the UK today, accounting for most of their huge rise in recent years (see figure 3). As a result, the BoE chose to suspend mandatory reserve requirements for commercial banks in 2009.

However, other major central banks including the European Central Bank (ECB) and the US Federal Reserve still in theory operate mandatory reserve requirements as a means to manage system-wide liquidity. In normal conditions, these requirements are increased to drain liquidity from the system, or decreased to release liquidity to the banks. This is the opposite mechanism to the build-up of voluntary reserves that has resulted from central banks' extraordinary easing facilities.

"Using the leverage ratio exemption, an increase in central bank reserves would likely lead to a mechanical decrease in the leverage ratio exposure measure and an improvement in banks' leverage ratios. All other things remaining equal, this could release capital to be deployed to other activities. But it is important to remember that mandatory reserves are a relatively small portion of overall central bank reserves held, so an exemption for them would not move the needle as much as the effect on voluntary reserves," says Monsur Hussain, a senior director for regulatory policy in the financial institutions team of Fitch Ratings in London.

The BoE has apparently sought to persuade the ECB behind the scenes to drop its mandatory reserve requirements altogether. With the advent of the Basel liquidity coverage ratio (LCR) to regulate banks' short-term liquidity management, BoE officials have privately questioned whether mandatory reserve requirements are needed any more as a tool to ensure banks can meet unexpected deposit outflows.

If the Fed and the ECB maintain their existing policy frameworks, however, the leverage ratio exemption could have the counter-intuitive impact of easing capital requirements when mandatory reserve requirements are hiked to tighten liquidity conditions. This is not significant today, but could resurface as an issue once QE is – eventually – unwound.