According to Moody’s, last Wednesday, the European Banking Authority (EBA) formally recommended the introduction of a minimum 3% leverage ratio for banks in the European Union (EU) by 1 January 2018.
The 3% leverage ratio would be credit positive for banks because it would become a complementary capital requirement to a bank’s risk-weighted capitalisation. As a non-risk sensitive measure, it would act as a backstop to risk-sensitive capital approaches and excessive internal model calibration of risk weights.
Before the introduction of the leverage ratio as a regulatory tool in the Basel III framework, banks used leverage as a means to increase profits by earning the premium between the expenses of the additionally raised funds and the yield of risky, often illiquid, investments. Banks that are highly leveraged are considerably more vulnerable than others to unexpected losses.
The EBA finds that among the 246 entities in its study’s sample, the aggregate capital shortfall for banks that do not yet comply with a 3% level would amount to €6.4 billion, based on a Basel III fully loaded Tier 1 definition over total exposure (including on- and off-balance sheet items). This amount is derived from shortfalls at 21 banks. However, as shown, the high sensitivity of shortfalls above this target ratio reflects the EU banking sector’s challenges in terms of deleveraging and adjusting business models (a 3.5% leverage ratio equates to a €25.4 billion capital shortfall; 4% = €84.9 billion; 4.5% = €166.7 billion; and 5% = €281.6 billion).
The EBA’s findings suggest that introducing the leverage ratio will have profound effects on business models, as reflected by the range of actual leverage ratios it found from 2.8% for public development banks up to 8.7% for automotive & consumer credit banks. In addition, its empirical findings from the benchmarking study show that small and medium-sized entities (The EBA defines small banks as entities with a total leverage ratio exposure below €10 billion and medium banks with an equivalent volume of €10 billion to €100 billion) are already in compliance with the suggested 3% leverage ratio. In this context, the EBA mentions that there is no need to deviate from this baseline requirement for smaller banks.
For our rated banks in the European Union, we find that the average leverage ratios (as measured by Tier 1 capital divided by total assets) for different countries is sufficiently above the minimum threshold of 3% as of 31 December 2015, as shown in Exhibit 2. However, the results vary considerably by country. Here is the EBA’s median and average leverage ratio from its benchmarking study.
The EBA’s recommendation is in line with the oversight body of the Basel Committee on Banking Supervision (BCBS) agreement in its January 2016 meeting, which also recommended a minimum level of 3% and in addition,
stricter requirements for global systemically important institutions.Likewise, the BCBS will finalize its calibration this year and the EBA intends take up further work along the committee’s findings. Additionally, it will also consider higher leverage ratio requirements for domestic systemically important institutions.
