Supplementary Leverage Ratio Could Damage Repo Industry

The supplementary leverage ratio would severely damage the repo industry and encourage banks to hold riskier assets in order to meet the recently proposed ratios, an industry expert has warned.

The supplementary leverage ratio has its roots in the financial crisis and the belief that banks’ previous risk weighted capital in some ways caused it. Banks were able to increase their exposure on instruments that had a low risk weighting but that understated their need for capital.

When the crisis hit, regulators felt that risk weighted capital calculations were insufficient and that risk weightings were pro-cyclical (in good times they go up and in bad times they go down). In 2009 the G20 proposed a non-risk weighted ratio that compared how much banks loaned against their capital. A new version was announced in June. Meanwhile, while most regulators have already imposed the ratio and the US has imposed a higher level on globally significant banks – 5-6% – compared to the Basel committee’s 3% measurement of capital as a percentage of banks’ exposure, or 33 x leverage.

The latest version of the leverage ratio means the regulators will not allow netting in repo, that is if money is borrowed and loaned in repo transaction regulators will not net the two. Instead they will only consider what has been lent, which makes a significant difference to the ratio, and apply a minimum that all banks should follow.

According to Richard Comotto, visiting fellow at ICMA, this will encourage banks to “get rid of low risk assets and focus their business on high risk assets.” He says: “If banks have government bonds on their balance sheet these are low risk weighted assets so you may be keeping very little capital [e.g. 1%] against them because the risk on them is low. If you are keeping 1% against those holdings, the leverage ratio suddenly says this leverage should be at least 3% capital coverage so you have to triple your capital. Whereas if you are holding a risky asset with a risk weighted of 5% that’s no problem you are already holding 5%.

“It will severely damage the repo business because it is generally against government bonds so it’s a low margin business but it’s been profitable because it has been a low capital business. Now if it becomes a high capital business because of the leverage ratio most banks will cut it back. If they cut back what they do in repo, liquidity in the repo market obviously drops and the cost of bonds goes up, particularly government bonds. So on the one hand they may fret about repo and on the other they may find some unhappy people around, particularly governments who would have to pay more for their borrowing.

“You are basically taxing lending. They [the regulators] can’t say they want people to people to stop lending and start lending unsecured because the whole structure of Basel is to encourage the use of collateral. So they are basically saying if you lend any money because it has collateral against they will penalize it by putting this capital charge but not if they collateralize against risky assets.”

Regulators are monitoring the effect of the new ratio from 2013 to 2017, when they will make a final assessment. However, the effect is being noticed across the industry and some banks have already begun to cut their exposures.