One of the major elements of the Basel III framework and its implementation in the European Union (EU) is the introduction of a leverage ratio. This is a bank’s supervisory Tier 1 capital (numerator) divided by its total exposure (denominator). Calculated this way, a low leverage ratio indicates that a bank has a high level of debt in relation to its Tier 1 capital. Valuations of balance sheet items for the purposes of calculating this ratio generally follow the relevant accounting standard applicable to the institution in question. Some special provisions have been included, however, to make the leverage ratio comparable across jurisdictions.
Unlike the procedure for risk-based capital requirements, which are also based on model assumptions, individual exposures are not individually risk-weighted for the purposes of calculating the leverage ratio but are instead included in the exposure measure unweighted. The leverage ratio is designed to address regulatory shortcomings that surfaced during the financial crisis, beginning in 2007. Thus, its aim is not only to counteract the fundamentally cyclical effect of risk-based capital requirements but also, as a supplementary, due to its risk-insensitive nature, to offset the weaknesses of risk-based capital requirements (backstop function). These drawbacks came to light during the crisis when, in some cases, the losses sustained by banks far outstripped the risks calculated on the basis of internal models.
The leverage ratio was introduced initially as a supplementary instrument that could be applied to individual institutions at the discretion of supervisory authorities (Pillar II). In December 2017, the Basel Committee on Banking Supervision (BCBS) then decided to make the provisional 3.0% target ratio a binding minimum requirement (Pillar I) from 2018 onwards.
In addition to the leverage ratio’s shift to a Pillar I requirement under the three-pillar model of prudential supervision, the finalised Basel leverage ratio framework introduces various technical changes to the methodology for calculating the ratio. Furthermore, from 2023, global systemically important banks (G-SIBs) will have their leverage ratio requirement increased by a capital add-on. This capital add-on should also consist of supervisory Tier 1 capital, and it amounts to 50% of the risk-based capital buffer for G-SIBs. Thus, a bank required to hold a risk-based G-SIB buffer of 2% would see its leverage ratio requirement of 3% rise by one percentage point to a total of 4%.
For the EU Member States, the Capital Requirements Regulation (CRR, Regulation (EU) No 575/2013) in its applicable version forms the legal basis for the leverage ratio requirements. Nationally, its scope was widened by the introduction of a broader definition of the term “institution”, however. For example, this definition also covers institutions that only take deposits and do not grant loans (Section 1a of the German Banking Act, Kreditwesengesetz).
To enable the risk of excessive leverage to be assessed, institutions report all the necessary information relating to the leverage ratio and its components to the national competent authorities on a quarterly basis. In addition, since 2015, institutions have been obliged to publicly disclose their leverage ratio and its components. With the application of the CRR II package, the leverage ratio became a binding minimum requirement within the EU as of June 2021. The introduction of CRR II will also see the capital add-on for G-SIBs being implemented in the EU from 2023, in line with the Basel Committee’s requirements.