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- Leverage ratio rules for banks: What changes & why it matters
Leverage ratio rules for banks: What changes & why it matters
The Reserve Bank of India has rolled out tighter leverage ratio norms for banks. This is expected to ensure capital adequacy in case of a financial crisis since the leverage ratio is calculated on the total value of the exposure without adjusting for risk, i.e., by assuming that the risk is 100%, writes Sebastian Morris.
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What do the final guidelines for the leverage ratio framework (LRF) say?
THE FINAL GUIDELINES on the revised Leverage Ratio Framework (LRF) bring India’s commercial banking regulations in line with the global Basel III “Leverage Ratio 2017 Standard” set by the Basel Committee on Banking Supervision (BCBS). The measure is a minimum capital requirement norm. It announces that banks must maintain a certain minimum ratio of Tier I capital to total exposure.
Tier 1 capital consists of:
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(1) The net worth of the bank in question measured conservatively, which is the paid-up equity share capital, share premium, statutory reserves, retained earnings all summed up less the intangible assets, deferred tax assets, and equity held in subsidiaries;
(2) Perpetual non-cumulative preference shares and debt instruments that have no finite maturity dates.
The “exposure” is essentially the size of the balance sheet minus permitted enhanced by the off-balance items (contingent liabilities) like letters of credit, financial guarantees, and commitments that would become loans in the future. Exposures on derivatives and securities financing transactions are all included, not as reported in the balance sheet but in a more conservative way as specified in the announced regulations. No netting of assets is permitted except under narrow guidelines.
The definition is in line with the Basel III norms and considers all liabilities that may arise in the future.
What is the minimum ratio for D-SIBs?
THE LEVERAGE RATIO comes into effect from April 1, 2027, and is somewhat different across banks. Domestic Systemically Important Banks (D-SIBs) — State Bank of India, HDFC Bank, and ICICI Bank, which are viewed as “too big to fail” financial institutions — need to maintain a minimum leverage ratio of 4%. Other banks (including foreign) are to maintain a ratio of 3.5%. The measurement of exposure is not risk adjusted. It includes the total exposure irrespective of risk.
What are the other regulatory measures?
A CLOSELY RELATED measure is the capital adequacy norm — the ratio of (Tier I and Tier II capital) to the value of risk weighted assets. Tier II capital includes subordinated debt, revaluation reserves. The requirement here is of 9% by the RBI, somewhat above the Basel III norm of 8%. There is a further qualification that Tier I must constitute at least 7%, and an additional buffer of 2.5% on Tier I (for drawdown during a crisis). So, effectively the requirement is 11.5% on the risk-weighted assets. The risk-weighted assets add all the assets with a risk weight that ranges from zero for cash, to 35% or so for home loans, 100% for lending to businesses, and 150% for unrated debt instruments.
What does it say about CRR?
THE CASH RESERVE ratio or the CRR is sometimes used as an instrument of monetary policy to increase/decrease the money in the system by decreasing/increasing the ratio. This works in a “tight reserve” regime that the RBI follows. It also results in the money multiplier being defined by the ratio of (1+cash/deposit)/ (CRR +cash/deposit). Since this is constant unless the CRR is changed by the RBI (the cash/deposit ratio being a near constant), the money supply can interalia be increased or decreased by lowering or raising the CRR respectively. The other methods are open market operations (when the RBI buys/sells bonds to increase/decrease the money supply), and discounting under the repo window (allowing banks to borrow with collateral).
Why are these changes being effected now?
CONTAGION IS WHAT makes all banks vulnerable in a system-wide crisis. The risk-weighted measure of assets could become useless since the risks typically go up during uncertainty and are amplified by the behaviour of banks. When there’s a perceived threat to the payments mechanism or the fundamental uncertainty is high, banks, fund houses and financial intermediaries will seek to have much higher levels of liquidity, all at the same time. They would do so by trying to sell assets such as stocks and bonds, whose values can then go into a free fall, negating any earlier assessed risk weights. This LRF will then act to ensure capital adequacy since it is calculated on the total value of the exposure without adjusting for risk, i.e., by assuming that the risk is 100%.
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What is its utility in a financial crisis?
IT WILL HELP in recovering from a mild crisis without too much intervention by the central bank. But it does not guarantee that a deep crisis will not happen. That is always possible, given the compositional fallacy (failure) that all financial markets have, and hence central bank intervention cannot be avoided. Walter Bagehot’s adage that the central bank must discount financial assets during a crisis remains. Standard macroeconomics too demands this. The measure has the one-shot cost of banks having to have a larger Tier I capital.
The writer is professor and chair, Centre for Public Policy and Governance, Goa Institute of Management.
This article was first uploaded on November three, twenty twenty-six, at twelve minutes past six in the morning.
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