Second in a nine-part series

Due to the extremely negative influence that leveraged banks had on the global economy in 2008-09, the 2010 Basel III reforms included a leverage ratio for the first time in the Basel Accords' history. Yet, a wide range of academics, regulators and financial reform advocates such as myself have felt that the Basel III leverage ratio of 3% is too low for globally systemically important banks.  

Fortunately, the recently released Basel III leverage ratio framework and disclosure requirements are a welcome update of the 2010 framework. The new guidelines will have a big impact on internationally active banks because they would require that banks' calculate high quality capital (retained earnings and common equity) to cover not only on-balance sheet assets, such as repo transactions, but also a broader array of off-balance sheet instruments, such as derivatives and letters of credits.

I have long awaited these guidelines, since the proposed leverage ratio is a necessary supplement to the current risk-weighted asset credit risk measurement and is crucial to making banks better capitalized to sustain unexpected losses. The new guidelines should assuage most concerns that Basel III does not go far enough in doing so, because de facto, a comprehensive leverage ratio is an important tool in reducing the size of GSIBs, many of which have become too big to manage themselves adequately.

The leverage ratio is not risk weighted, unlike under Pillar I, where GSIBs using the Advanced Internal Ratings Based approach are allowed to calculate their own RWAs for credit risk capital allocation. This is an important distinction and makes the leverage ratio more credible than using only RWAs.

Critics of the proposed guidelines argue that the leverage ratio would encourage banks to transact riskier on- or off-balance sheet instruments. If banks were to do that, however, this added riskiness would raise banks' RWAs and force them to increase their capital. This action would also impact their liquidity coverage ratio by making the banks less liquid since most risky assets do not count for the LCR. This is another reason why the leverage ratio is an important complement to the RWA and liquidity buffers.

While the proposed leverage ratio remains at 3%, the updated guidelines make significant changes to its denominator, the exposure measure. Expanding the denominator is important, because repo transactions and certainly derivatives have credit, market, liquidity and operational risks that can appear unexpectedly and severally erode a bank's earnings, not to mention wipe out a bank's capital.

Some countries, including the U.S., have leverage requirements that only encompass on-balance sheet assets, but leave out off-balance sheet instruments making a bank look better capitalized than it really is. In the U.S., for example, recent OCC data show that while the top eight GSIBs have assets ranging from $80 billion to almost $2 trillion, their derivatives' portfolios represent significant multiples of their on-balance sheet assets, between $1 trillion to $70 trillion. In fact, due to the accounting treatment of derivatives under generally accepted accounting principles, U.S. banks appear smaller than they would under international financial reporting standards. Hence, a leverage ratio has to include derivatives to be meaningful.

Before the crisis, banks were not adequately focused on whether they had sufficient capital to survive when a derivatives' counterparty suffered a credit event, such as default. The new exposure measure has several key requirements for financial derivatives that would force banks to rethink whether such derivatives portfolios are worth the added leverage buffer. For example, for all interest rate, foreign exchange, equity, commodity and credit derivatives, the new leverage ratio would have to capture two key types of derivatives exposure: exposure arising from the contract's underlying reference asset and a counterparty credit risk exposure.

The proposed guidelines also have additional requirements for credit protection sellers. The full effective notional value referenced by a written credit derivative must be incorporated into the exposure measure. This new requirement is significant because a credit derivatives' writer now would have to include her entire contingency liability in the leverage ratio's denominator. This would increase the likelihood that a bank would be better capitalized for an unexpected loss arising from being a credit protection seller, something that can happen without much warning.

Additionally, the new guidelines are better than the leverage buffer in the 2010 Basel III framework, because they require banks to disclose publicly the different components included in the leverage ratio. Unlike what many argue, simply raising the leverage ratio won't necessarily address all problems: What is in the numerator and the denominator makes all the difference. Banks attempt to get many different assets allowed in the numerator and as little covered in the denominator. Disclosure is key if there is any hope that the leverage ratio will have any credibility. Otherwise, it runs the risk of being eyed with the same suspicion and derision as risk-weighted calculations.

The leverage consultative document is open for comment until September 20. Until then, rest assured, there will be significant lobbying for and against the proposal on both sides of the Atlantic. Further intensifying the debate about the proposed Basel III leverage ratio is the fact that the Federal Deposit Insurance Corp. recently recommended that U.S. bank holding companies and deposit-insured subsidiaries have a leverage ratio of 5% and 6%, respectively. This is significantly higher than the 3% proposed by the Basel committee. Yet, the denominator for the U.S. leverage ratio is still based on the 2010 framework, which is not as encompassing as what would be required in the Basel Committee's June guidelines.

In the U.S., lobbyists are arguing that a stronger leverage ratio puts U.S. banks at a competitive disadvantage against European banks. Given the condition of most European banks, that attempt to strike fear in U.S. politicians should not hold weight. What really puts our country at a competitive disadvantage in comparison to other faster growing countries is the tremendous negative impact that very leveraged banks can and have inflicted on the American people.

Next: A look at the importance of the Basel Committee's first report on the regulatory consistency of risk-weighted assets for credit risk.

Mayra Rodríguez Valladares is Managing Principal at MRV Associates, a New York based capital markets and financial regulatory consulting and training firm. She is also a faculty member at the New York Institute of Finance.