Regulator views on leverage ratios firming

With the Financial System Inquiry due to hand its final report to Treasurer Joe Hockey before the end of this month, the major banks seem to have resigned themselves to having to increase capital above current requirements if comments made by CEOs, such as Gail Kelly in recent days, are anything to go by.

Moreover, the general view is that the FSI will want to see an increase in real equity implemented, not just an increase in hybrid capital.

Currently, the minimum common equity tier one capital required by APRA is set at 4.5 per cent of risk-weighted assets. From 1 January 2016, a capital conservation buffer of 2.5 per cent comes into effect, as does a counter cyclical buffer, which could add as much as a further 2.5 per cent to the minimum CET1 ratio imposed on banks.

In addition, the D-SIB capital impost on the major banks will also come into effect from 1 January 2016. This impost is expected to be one per cent.

This means a minimum CET1 ratio of at least eight per cent of risk-weighted assets will apply for the major banks in a little over 12 months from now. But, as outlined earlier in today's edition, consensus is building among regulators that this is not enough.

The major banks have all been pleased to announce with their full year results that their CET1 ratios exceed this minimum requirement already. But if regulator focus shifts to leverage ratios, they will have more to do.

At present, the leverage ratios of the major banks average around four per cent, based on on-balance sheet assets. This means total assets are around 25 times the banks' capital.

As a part of the Basel III reforms, the Basel Committee on Banking Supervision (BCBS) has stipulated that a minimum leverage ratio of three per cent will come into effect from 1 January 2018. The leverage ratio will be based on a bank's total economic exposures (on and off-balance sheet assets) divided by the capital available to support the exposures. No risk weightings are applied.

US regulators snorted that such a ratio is weak. In May this year, US banking regulators (the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System and the Federal Deposit Insurance Corporation) introduced regulation for a leverage ratio to be applied all US banks that use the internal rating based approach to determine risk weights for their assets.

From 1 January 2018, US bank holding companies will be required to meet a minimum leverage ratio of five per cent. In other words, the holding companies can be geared no more than 20 times.

Their FDIC insured deposit taking subsidiaries will need to meet a minimum leverage ratio of six per cent. In other words, gearing cannot exceed 16.7 times.

Last week, the UK's Financial Policy Committee announced its recommendations for the implementation of a leverage ratio for UK banks. The announcement follows a review commenced a year earlier and subsequent consultation.

The UK's FPC has also decided to go beyond the minimum specified by the BCBS, and brought the implementation date forward. For UK G-SIBs, the implementation date will be 1 January 2016 but the later date will apply for other UK banking institutions.

The FPC is recommending a minimum ratio of three per cent plus 35 per cent of the G-SIB buffer, which could range from one per cent to 2.5 per cent of risk-weighted assets, plus 35 per cent of any counter-cyclical buffer. Both additions could take the leverage ratio to 4.75 per cent (or a maximum gearing of 21 times) for a UK G-SIB.

The UK leverage ratio for G-SIBs is certainly not as tough as the one proposed for US banks. Moreover, the US ratio is based on CET1 capital, while the FPC has said that three per cent portion of CET1 capital can include up to 25 per cent of Additional Tier 1 capital, for the purpose of calculating the minimum requirement.

But there is a catch. The Additional Tier 1 capital can only be counted if the capital conversion trigger on the instruments is set at seven per cent, and not the standard 5.125 per cent. In other words, the instruments must be capable of converting to equity while the bank is still a going concern and not as it is about to become a gone concern.

This option is not currently available to Australian banks, as all Additional Tier 1 capital has the capital trigger set at 5.125 per cent and not seven per cent.

The Financial Stability Board is due to make its recommendations on the subject to the G20 Leaders meeting in Brisbane later this week.

With the FPC having announced its position, the FSB has an opportunity to take a line that falls between that of the FPC and US regulators.

Between the FSI recommendations and those from the FSB, it is inevitable that APRA will soon set out its intentions for the implantation of a leverage ratio to be applied to Australian banks. The banks will then know how much more capital they will have to raise.

The introduction of Additional Tier 1 Capital with a seven per cent conversion trigger would be an interesting development. How much larger will the notional dividend have to be to persuade retail investors to accept the increased risk of conversion?