WASHINGTON — Banks may soon have their best chance in years to push for certain exemptions to regulators’ leverage-based capital rules, even as market critics argue that such changes would be a Wall Street giveaway.

Bank have long argued that the leverage ratio — part of the Basel III accords agreed to by G-20 nations after the financial crisis — is too onerous, penalizes good behavior and incentivizes the assumption of greater risk.

With the election of President Trump, congressional efforts to roll back regulations and buy-in from key regulators, those concerns have increasingly found support in the government, signaling that changes to the leverage ratio calculation are gaining traction.

Federal Reserve Board Gov. Jerome Powell
“A risk-insensitive leverage ratio can be a useful backstop," but it "can have perverse incentives if it is the binding capital requirement," said Federal Reserve Board Gov. Jerome Powell. Bloomberg News

“There is a broad and growing consensus that this reform is really important and needs to get done,” said Greg Baer, president of the Clearing House Association.

A principle behind the leverage ratio, a non-risk-based capital measure, is that applying different risk weights to assets could allow banks to manipulate the system to lower their capital requirement. The leverage ratio, therefore, treats all assets the same.

On one side, banks argue that a one-size-fits-all risk classification ignores the risk disparity between different assets, including zero-risk assets. They argue that certain assets should be removed from the ratio altogether. But big-bank critics disagree.

Gregg Gelzinis, special assistant to the economic team at the Center for American Progress, said there is clearly momentum for regulators to revisit the supplementary leverage ratio, but he said those changes would undermine the integrity of the capital rules.

“I definitely think, with conservatives controlling all branches of government, there is movement here to alter the supplementary leverage ratio,” Gelzinis said. “Is that a good thing? We definitely think it’s not.”

The U.S. capital rules establishing a leverage ratio were passed in 2013, requiring all banks with more than $250 billion in assets or $10 billion in foreign exposure to hold at least 3% non-risked-based capital relative to assets. Regulators later passed the “enhanced” SLR — or eSLR — that applied only to the eight global systemically important banks. The eSLR requires those banks to hold 5% capital at the holding company level and 6% capital at the bank level. Those rules will be fully implemented Jan. 1.

Banks have said that the leverage ratio’s failure to take into consideration low-risk assets like cash on deposit at Federal Reserve banks, Treasuries or margin held against derivatives transactions, are unfairly punitive, since those assets are required by other sections of Dodd-Frank or the Basel accords.

In its highly anticipated report last month, the Treasury Department said that it is “important to address unfavorable impacts [the eSLR] may have on market liquidity and low-risk assets,” with particular attention to those three asset classes.

The argument has met other sympathetic ears as well. Federal Reserve Gov. Jerome Powell — who heads the Fed’s supervisory committee pending the confirmation of Randal Quarles as the Fed's vice chair of supervision — said that, though the leverage ratio has a purpose, its effects become undesirable when it is the primary capital constraint.

“A risk-insensitive leverage ratio can be a useful backstop to risk-based capital requirements,” Powell said in a speech last month. “But such a ratio can have perverse incentives if it is the binding capital requirement, because it treats relatively safe activities, such as central clearing, as equivalent to the most risky activities.”

Powell went on to lay out a handful of policies under consideration, including one being examined by the Basel Committee on Banking Supervision that would make the SLR proportional to the risk-based capital standards. The Fed is also considering a move that would consider certain types of margin posted for derivatives contracts as settlement payment rather than collateral, thus reducing the exposure to the SLR, he said.

Aaron Klein, a fellow at the Brookings Institution and policy director at the Center on Regulation and Markets, said the banks likely have a legitimate grievance to the extent that other rules have had a negative and likely unintended consequence when it comes to the leverage ratio. This includes the liquidity coverage ratio, or LCR, which requires banks to hold additional liquid assets at all times, and required central clearing of derivatives. But changing the leverage ratio may not be the solution that regulators are looking for, Klein added.

“I’m a big fan of the chopsticks approach, which includes a simple leverage ratio and a complex one,” he said. “You have to be comfortable alternating between the two, and that doesn’t mean to try to move the simple one to make it a little more complex and move the complex one to make it a little more simple.”

Marcus Stanley, policy director for Americans for Financial Reform, went further, saying that if you’re going to have exemptions in the leverage ratio, then you effectively do not have a leverage ratio at all.

“If we go down this road of making special arguments for each different asset about how risky it is, we’ve just reproduced the risk-based capital ratio,” Stanley said. “And so the next argument is, why do we have two risk-based capital ratios? These are large, significant institutions by definition, and they need to have a minimum amount of capital, and that is what the leverage ratio is for.”

But fears that exemptions for certain assets — like those outlined by the Treasury report — would open the door to all manner of exemptions are overblown, Baer said. The Bank of England, he noted, made similar exemptions last summer — reforms that have not affected other asset classes.

“Nobody got cash wrong in the crisis, and nobody got U.S. Treasuries wrong in the crisis,” Baer said. “The Bank of England has already done this, and they haven’t gone down some slippery slope where they have to deduct subprime mortgages from the denominator. They’re able to maintain that distinction.”

Karen Shaw Petrou, managing partner at Federal Financial Analytics, said that though there appears to be no political impediment to exemptions in the leverage ratio, the proposed exemptions are not equally palatable. Exempting cash in Federal Reserve accounts may be the lowest-hanging fruit, she said, but even that change may have strong opponents among the existing leadership at the Federal Deposit Insurance Corp. and the Fed.

“The change on excess reserves — and reserves in general — is the most likely of these changes,” Petrou said. “The broader changes that Treasury proposes, for Treasury obligations and margin, will really depend on the next round of regulators. I’m not sure this Fed or the FDIC would accept them.”

FDIC Vice Chair Thomas Hoenig, who has been a vocal critic of risk-based capital rules and a strong proponent of the leverage ratio, said he is strongly opposed to the idea of carving out exemptions to the leverage ratio. Hoenig said any such changes would be a “serious error” and undermine a capital regime that makes the U.S. banking system the envy of the world.

“It is quite useful in telling the public and the market what the capacity of the institution is to absorb loss from any source, whether it’s assets, operational, market risk and so forth,” Hoenig said. “It gives you a real sense of where they are, rather than … reducing their balance sheet to make their ratio look stronger, which is what happens with the risk-based measure.”

Hoenig did say he might be amenable to adjusting the leverage ratio for the custody banks — namely BNY Mellon and State Street — that have relatively low-risk business models but are disproportionately affected by the leverage ratio. But lowering the leverage ratio is a different conversation than poking holes in it, he said.

“Even [with custody banks] you want to be careful," he said. "I might change the minimum requirement for what the leverage ratio is, but wouldn’t eliminate it. If we’re going to argue about what the right number is, OK."

Klein agreed that the problem with regulatory exemptions is that they can make institutions appear better-capitalized than they really are. He noted that this occurred in the financial crisis, when the Fed allowed banks to keep assets off of their balance sheets in the form of structured investment vehicles, or SIVs. While losses to SIVs were not supposed to impact the parent company, Klein said, in practice the banks brought them back on the balance sheet when they became distressed.

“One of the searing lessons from the financial crisis was the Fed’s ability to allow institutions to keep things off-balance sheet, which made all of their capital metrics appear stronger than they were, particularly with … SIVs,” Klein said. “[That] was a major regulatory failing of the Fed. You have to be very careful when you start creating exemptions.”

Gelzinis said the point of a leverage ratio is to provide a fail safe to protect against whatever might go wrong with risk weighting. No matter the asset, he said, something can always go wrong.

“It’s fair to assign them a zero risk weight for risk-based capital requirements, but leverage requirements gain their benefit from regulators not having to predict how a crisis might occur or impact bank losses,” Gelzinis said. “What if, during a financial crisis, we have a flash crash in the Treasuries market? All of a sudden these capital changes … would come to bite us.”

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