Banking StandardsLetter from the Chancellor of the Exchequer

Leverage Ratio: International Comparisons and Definitions

When I appeared before the Commission on 25 February, I was asked to comment on the different minimum leverage ratios that are applied internationally. The Commission rightly noted that some countries operate higher minimum leverage ratios than the 3% proposed under Basel III. It is, however, important to note that these different leverage ratios are calculated on a different basis from the Basel III standard, with the result that the minimum levels set according to the different standards are not directly comparable. This was recognised by Mark Carney in his recent evidence to the Treasury Select Committee, when he acknowledged that comparing different leverage ratios could be an “apples and oranges comparison”.

For example, the minimum leverage ratio according to the definition used by the US Federal Reserve differs from the Basel III leverage ratio in that it both excludes off-balance-sheet exposures (captured within the Basel III definition) and uses the US GAAP accounting standard (rather than IFRS) to calculate total assets, which allows greater netting of derivatives. Both of these differences will mean that a given bank would appear to have a higher leverage ratio (ie would appear less leveraged) according to the US definition than under the Basel III definition. Similarly, the minimum leverage ratio used in Canada is calculated using a bank’s total regulatory capital, not just its Tier 1 capital as in Basel III. This too will tend to make banks appear less leveraged according to the Canadian than the Basel III approach.

A different definition still of the leverage ratio has been used by the Bank of England in their Financial Stability Reports: this definition uses total equity (which is narrower than Tier 1 capital) divided by total assets (excluding off-balance sheet exposures). Leverage ratios calculated according to this definition—which was also the approach used by the ICB in its publications1—will not, therefore, be directly comparable to Basel III leverage ratios.

To illustrate how much difference the choice of definition used can make to a bank’s leverage ratio, I have included below a simplified illustrative bank balance sheet showing the key relevant variables. The leverage ratio for this illustrative bank is then calculated according to a range of different international standards. As you will see, depending on the definition used, the same illustrative bank’s leverage ratio varies from a minimum of 3.08% (under the Basel III definition) to a maximum of 5.34% (under the US Federal Reserve definition).

This shows that it is not, therefore, valid simply to compare the minimum values for the leverage ratio set in different jurisdictions, without taking account of the different definitions according to which leverage ratios are to be calculated. The Government strongly supports the Basel III Accord, including its proposal for a minimum leverage ratio as a backstop to risk-weighted capital requirements. The Basel III definition of the leverage ratio, which measures Tier 1 capital only against a bank’s total exposures, including off-balance-sheet exposures, is the most prudent standard available. The Government has consistently pressed for the full implementation of the Basel III Accord, in the EU though European legislation.

I am copying this letter to members of the Parliamentary Commission on Banking Standards.

George Osborne

Annex

IMPACT OF DIFFERENT LEVERAGE RATIO DEFINITIONS

Illustrative Bank Balance Sheet

Assets

£millions

Liabilities

£millions

Funded Assets

£750,000

Liabilities exc Derivatives

£700,000

Derivative Assets

£400,000

Derivative Liabilities

£395,000

Total Capital

£55,000

of which:

  Tier 2 Capital

£15,000

  Tier 1 Capital

£40,000

  of which:

    Non-Equity Tier 1 Capital

£3,000

    Equity

£37,000

    of which:

      Intangibles

£1,000

      Tangible Equity

£36,000

TOTAL

£1,150,000

TOTAL

£1,150,000

Total Exposures (Basel III definition)

£1,300,000

Leverage Ratios According to Different Definitions

Leverage Ratio Standard

How calculated

Resulting Leverage Ratio

Basel III

Tier 1 Capital/Total Exposures

3.08%

US Federal Reserve

Tier 1 Capital/Tangible Funded Assets

5.34%

OSFI (Canada)

Total Capital/Total Assets plus Off-Balance-Sheet Exposures

4.23%

Bank of England

Equity/Total Assets

3.22%

Tangible Equity

Tangible Equity/Total Assets with netted derivatives

3.14%

8 March 2013

1 See, for example, Figure 4.3 on page 98 of the ICB Final Report.

Prepared 19th June 2013