Ever-changing leverage ratio framework may cause regulation fatigue

The revised EU Capital Requirements Directive and Regulation, commonly referred to as CRD 5 and CRR 2, refine and continue to implement Basel III framework in the EU. One of the key rules introduced under Basel III is the leverage ratio. CRR 2, which broadly reflects the Basel leverage ratio, sets the Tier 1 capital-based leverage ratio requirement at 3% for all EU banks as per the EBA’s recommendation.

Banks are committing significant time and resource to assessing and adopting the new standards while they are subject to headwinds driven by a lack of clarity, as well as the sheer volume of regulation and instances of inconsistency between regulations. For instance, the current Basel III leverage ratio is based on the Basel Committee’s 2014 design. But, starting from 2022, banks will have to apply the updated Basel IV leverage ratio, which was introduced in December 2017.

The Basel IV leverage ratio rules include additional rules set out for global systemically important banks and make certain amendments to the exposure measure used in the calculation of the ratio. So, as far as leverage ratio is concerned, the way forward appears challenging as complexities pertaining to global coordination and to 'fatigue' are growing. In the UK, the Prudential Regulation Authority (PRA) already applies a more stringent regime, requiring firms with retail deposits over £50bn to have minimum leverage ratio of 3.25%, with at least 75% of the ratio to consist of Common Equity Tier 1 capital.

Compliance with the new framework is already challenging on its own and any further changes either at the domestic or global level are likely to create further complexities in terms of meeting the minimum leverage ratio requirement and the accompanying reporting and disclosure requirements, as well as the PRA’s governance requirements for reporting and disclosing their leverage ratios. Some practitioners are already concerned that some of the new rules may not have the long-term results intended by the regulators. So regulators would be expected to refrain from imposing additional rules on leverage ratio.

But with the Basel Committee’s October 2018 statement on potential regulatory arbitrage concerns, the leverage ratio goalposts are now likely to move once again in the limelight. Pointing at the heightened volatility observed in various segments of money markets and derivatives markets around quarter-end dates, the Committee is considering taking action to prevent firms from engaging in short-term balance sheet management strategies to boost their leverage ratio on reporting dates. Given that the Basel rules require firms to calculate the leverage ratio on a quarter-end basis, the Committee is advising national supervisors to focus on monitoring transaction volumes and volatility between reference dates to address potential window-dressing behaviour across firms and to ensure an accurate view of their risk profiles.

The UK Financial Services and Markets Act 2000 prohibits knowingly or recklessly disclosing misleading information and the PRA requires firms to calculate an averaged leverage ratio over a reporting quarter, based on daily on-balance sheet assets averaged over the quarter as well as monthly off-balance sheet exposures averaged over the quarter. So the Committee’s recommendation may appear not to have any immediate implications for the UK firms. Yet, it is still likely to lead to nuanced changes to the PRA’s supervisory approach.

The PRA currently takes into account the potential difficulties in valuing certain accounting assets at the end of each day and allows firms to use ‘best estimates’ as long as ‘they are measured consistently and prudently’. This currently gives some firms which are struggling to meet the requirement leeway to boost their leverage ratios. Considering the Committee’s recent statement, the PRA will be expected to introduce more stringent measures. The Basel Committee is also planning to introduce additional measures, including new Pillar 1 and Pillar 3 requirements, which are also likely to be reflected in the PRA’s supervisory approach.

The UK leverage ratio framework is already subject to further changes with the PRA’s December 2018 Policy Statement PS32/18 extending additional leverage ratio buffer to UK domestic systemically important institutions and its application of the framework to systemic ring-fenced banks in scope on a sub-consolidated basis from January 2019. Adding another level of complexity, the Financial Policy Committee is also planning to undertake a review of the UK leverage ratio framework.

As disclosed in the PRA’s October 2018 updated approach to banking supervision, the UK minimum leverage requirement of 3.25%, which currently applies only to banks and building societies with retail deposits equal to or greater than £50 billion on an individual or a consolidated basis, is now likely to be extended to all banks in the spirit of forthcoming CRR2, which is expected to be published in the EU’s Official Journal in June 2019.

So the end of regulatory changes is not yet in sight and uncertainty remains a key challenge for firms in scope. The leverage ratio requirement is already a contentious issue amidst industry concerns on its impact on repo and clearing services and it is unequivocal that evolving rules on the leverage ratio will continue to be a major challenge for the industry.  Banks are already fatigued by the cost and scale of regulatory compliance. A further signal of potential change to the framework which would entail even more implementation work for the industry would only contribute to the frustration amongst market participants and scepticism as to whether the constantly evolving leverage ratio regime will ever meet its goals.

Mete Feridun is a Manager in PwC’s Financial Services Risk and Regulation practice. Prior to joining PwC, he worked at the Financial Conduct Authority.

Disclaimer: The views and opinions expressed in this blog are those of the author and do not necessarily reflect the official views and opinions of PwC.