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). A low figure indicates a high level of debt in relation to tier 1 capital. The balance sheet valuations are oriented to the relevant accounting standard applicable to that particular institution. Some special provisions have been included so as to make the leverage ratio internationally comparable.
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 metric value unweighted. The leverage ratio is designed to address regulatory shortcomings that surfaced during the financial crisis. Not only should it counteract the fundamentally cyclical effect of risk-based capital requirements but, as a risk-insensitive instrument, it should also offset the weaknesses of risk-based capital requirements (the backstop function). Such flaws came to light during the crisis when, in some cases, the losses sustained by banks far outstripped the risks calculated on the basis of models.
The leverage ratio was introduced initially as a supplementary feature that could be applied to individual institutions at the discretion of supervisory authorities (Pillar 2). In December 2017, the Basel Committee on Banking Supervision (BCBS) then decided to make the provisional 3.0% target ratio a binding minimum requirement from 2018 onwards.
In addition to incorporation into 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 2022, a capital add-on will raise the leverage ratio requirements for global systemically important banks (G-SIBs). This capital add-on should also consist of supervisory tier 1 capital and amount to 50% of the G-SIB risk-based capital buffer. For example, if a bank is required to hold a 2% risk-based G-SIB capital buffer, its leverage ratio would be subject to a 1% increase and would thus rise to a total of 4%.
The Basel standards are recommendations and not legally binding. Implementation of the guidelines is a matter for the discretion of the participating jurisdictions. In Germany, therefore, it is the rules set by the EU which determine their application.
For the EU Member States, the Capital Requirements Regulation (CRR, Regulation (EU) No 575/2013), supplemented by a Delegated Regulation (Delegated Regulation (EU) 2015/62), forms the legal basis for the leverage ratio requirements. Its scope was widened by the use of a broader definition of the term "institution", however. For example, it also covers institutions that only take deposits and do not grant credit (section 1a of the German Banking Act, Kreditwesengesetz).
So that the risk of excessive leverage can be assessed, institutions report all required information relating to the leverage ratio and its components to the national supervisory authorities on a quarterly basis. In addition, since 2015, institutions have been obli ged to publicly disclose their leverage ratio and its components. Currently, the leverage ratio is not yet a minimum requirement in the EU, but the European Commission’s November 2016 proposal for a review of the CRR does include plans to make it one.
Implementation of the finalised Basel guidelines in the EU is set to take place as part of the ongoing revision of the CRR and CRD IV. The date from which the EU rules will apply will primarily depend on when the amended legal acts are published in the Official Journal of the European Union.