Basel III Leverage Ratio Causes Concern

The Basel III leverage ratio is emerging as a critical issue, said Richard Barfield, a director at consultancy firm PwC.

Mr Barfield's comments came after the Basel Committee reported data indicating major international banks would have fallen significantly short of Basel III capital rules if they had been in effect last year.

The data was based on a monitoring exercise undertaken by the Committee.

The 212 banks that participated in the study included 103 Group 1 banks (those that have Tier 1 capital of more than €3 billion and are internationally active) and 109 Group 2 banks (all other banks).

While the Basel III framework sets out transitional arrangements to implement the new standards, the monitoring exercise results assume full implementation of the final Basel III package based on data as of 30 June 2011.

The study found that based on the data and applying the changes to the definition of capital and risk-weighted assets, the average common equity Tier 1 capital ratio (CET1) of Group 1 banks was 7.1%, as compared with the Basel III minimum requirement of 4.5%. In order for all Group 1 banks to reach the 4.5% minimum, an increase of €38.8 billion CET1 would be required, said the Committee. The overall shortfall increases to €485.6 billion to achieve a CET1 target level of 7% (including the capital conservation buffer); this amount includes the surcharge for global systemically important banks where applicable.

For Group 2 banks, the average CET1 ratio stood at 8.3%. In order for all Group 2 banks in the sample to meet the new 4.5% CET1 ratio, the additional capital needed is estimated to be €8.6 billion. They would have required an additional €32.4 billion to reach a CET1 target 7%.

The leverage ratio is the ratio of Tier 1 capital to certain on and off balance sheet exposures, calculated in accordance with the methodology set out in the Basel III guidelines published in December 2010. The monitoring exercise found that under the current Tier 1 leverage ratio, 17 banks (six Group 1 and 11 Group 2) would not meet the 3% Tier 1 leverage ratio level. Under the Basel III Tier 1 leverage ratio this leaps to 63 banks that would not meet the 3% Tier 1 leverage ratio level; 36 of those Group 1 banks and 27 Group 2 banks.

"The results show that the leverage ratio is starting to emerge as a critical issue. This might have gone under many people's radars as banks may hit the capital ratio (which is the main focus) but still fall short on the leverage ratio," said Barfield.

"It is worrying that 36 of the 103 Group 1 banks would not have met the Basel III leverage ratio of 3% as this could lead to deleveraging in order to make up the shortfalls."

Banks need to be careful to avoid a knee-jerk reaction that leads to deleveraging, which may damage their long term profitability, he added. It also raises the question as to what banks could be doing to improve investor confidence in the sector to increase the supply of capital. This is essential to ensure that the transition to Basel III does not have damaging consequences at a time of economic fragility.

In its report, the Basel Committe said the treatment of deductions and non-qualifying capital instruments had affected figures reported in the leverage ratio section. "The underestimation of Tier 1 capital will become less of an issue as the implementation date of the leverage ratio nears. In particular, in 2013, the capital amounts based on the capital requirements in place on the Basel III monitoring reporting date will reflect the amount of non-qualifying capital instruments included in capital at that time. These amounts will therefore be more representative of the capital held by banks at the implementation date of the leverage ratio."