WASHINGTON Regulators have been intensely negotiating revising a leverage ratio under the Basel III capital rules, prompting rumors on what approach policymakers will take and just how far they may go.
Officials at the Federal Reserve Board, the Federal Deposit Insurance Corp., and the Office of the Comptroller of the Currency are in the final stages of finalizing the Basel III rules, which could be released early next month.
In the midst of those discussions, the agencies have been debating whether to boost a leverage ratio initially set as a minimum of 3%, but which has been criticized for being too low to protect the banking system. The largest financial institutions will also be subject to an additional 3% supplemental ratio under the current proposal released last June.
We offer the following frequently asked questions about what regulators are planning.
Q: Do all the regulators agree that there should be a higher leverage ratio?
A: Yes, though there has been debate on exactly how high it should go. In separate speeches, officials from all three agencies have said they believe it's worth improving the leverage ratio, given the proposal's overreliance on a risk-based capital system. Both FDIC Vice Chair Thomas Hoenig and board member Jeremiah Norton have argued the current risk-weighting regime has proven unable to accurately capture risk. Fed Gov. Daniel Tarullo has also weighed in on the issue, suggesting that the supplemental leverage ratio "may have been set too low." Comptroller of the Currency Thomas Curry has also signaled he supports an increase in the ratio.
Q: How high do regulators want to raise the leverage ratio?
A: It's not entirely clear, although most analysts suspect a revised leverage ratio for U.S. banks to range from 4% to 8%. Fed and OCC officials have both refrained from providing figures. Hoenig, however, has advocated lifting the ratio as high as 10%, while his counterpart Jeremiah Norton, who has also argued for an improved leverage ratio, has refrained from endorsing a specific number. Former FDIC Chairman Sheila Bair has called for an 8% leverage ratio.
Q: What approach could regulators take?
A: There are two different ways regulators could decide to increase the leverage ratio. They could opt to target the largest banks by raising the supplemental leverage ratio, which applies only to the biggest institutions and accounts for off-balance sheet exposures. But regulators might also conclude that increasing the supplemental ratio could make it too challenging for banks to calculate their ratios and simply boost the minimum leverage ratio instead.
Q: What are the issues that regulators are still ironing out?
A: One of the key issues regulators are wrestling with in the negotiations is how to value derivatives exposure because it will have significant implications for the leverage ratio. One method they could opt to use is the "current exposure method," which was used in Basel I and II. The OCC, for example, endorsed that approach in a recent rule, which will require national banks to take into account exposure to derivatives on their lending limits. Another approach supervisors could take is to use internal models by the firms, but that would have to meet quantitative and qualitative criteria and could be stress tested before they could be used.
Q: Is that it?
A: Another major issue is the treatment of accounting rules and whether U.S. or international laws will be applied and the impact it has on "netting." It's commonly understood that depending on the two different accounting regimes, the same firm could end up with two very different leverage ratios. It will be awhile before global regulators will be able to reach consensus on that issue.
Q: When could we see a final Basel III package?
A: Regulators will likely roll out a final Basel III rule "very soon," according to Fed Chairman Ben Bernanke. Earlier this year, Tarullo hinted the final rule could come out in June, prompting many to speculate that a proposal could be released as early as next week. Looking at the calendar, however, that seems increasingly unlikely. Regulators are required to provide advanced notice before holding a Board meeting to discuss a rule by at least 7 days.
Q: Will the leverage ratio be included in the Basel III package?
A: No. Given that the regulators proposed the minimum leverage ratio at 3%, they would be required under the law to re-propose that part of the rule if they had plans to increase it. It seems increasingly likely that regulators may opt to do an advanced notice of proposed rulemaking, which would ask a far greater number of questions before proposing any specific ratio.
Q: Could regulators use an alternative method to increasing the leverage ratio without re-proposing it?
A: Yes. Tarullo recently suggested that regulators could set a higher leverage ratio for firms with $50 billion or more in assets under a set of rules under the Dodd-Frank Act known as Sec. 165. But there are still a number of unknowns on how regulators would go about that.