TWN Info Service on Finance and Development (Apr16/01)
12 April 2016
Third World Network

BCBS proposes revisions to Basel III leverage ratio framework
Published in SUNS #8216 dated  7 April 2016

Geneva, 6 Apr (Kanaga Raja) -- The Basel Committee on Banking Supervision (BCBS) on Wednesday (6 April) released a consultative document, proposing revisions to the design and calibration of the Basel III leverage ratio framework.

According to a BCBS press release, the Basel III framework, published in January 2014, introduced a simple, transparent, non-risk-based leverage ratio to act as a supplementary measure to the risk-based capital ratio.

The proposed changes to the framework are an important element of the regulatory reform programme that the Basel Committee has committed to finalise by end-2016, it said.

The proposed revisions to the Basel III leverage ratio framework encompass the following:

* to measure derivative exposures, the Committee is proposing to use a modified version of the standardised approach for measuring counterparty credit risk exposures (SA-CCR) instead of the Current Exposure Method (CEM);

* to ensure consistency across accounting standards, two options are proposed for the treatment of regular-way purchases and sales of financial assets;

* clarification of the treatment of provisions and prudential valuation adjustments for less liquid positions, so as to avoid double-counting; and

* alignment of the credit conversion factors for off-balance sheet items with those proposed for the standardised approach to credit risk under the risk-based framework.

The Committee has welcomed comments from the public on all aspects of the proposals outlined in the document by 6 July 2016.

According to the BCBS document, titled "Revisions to the Basel III leverage ratio framework", an underlying cause of the global financial crisis was the build-up of excessive on- and off-balance sheet leverage in the banking system.

In many cases, banks built up excessive leverage while apparently maintaining strong risk-based capital ratios.

"At the height of the crisis, financial markets forced the banking sector to reduce its leverage in a manner that amplified downward pressures on asset prices. This deleveraging process exacerbated the feedback loop between losses, falling bank capital and shrinking credit availability."

The Basel III framework introduced a simple, transparent, non-risk-based leverage ratio to act as a credible supplementary measure to the risk-based capital requirements.

The Basel III leverage ratio is intended to: restrict the build-up of leverage in the banking sector to avoid destabilising deleveraging processes that can damage the broader financial system and the economy; and reinforce the risk-based requirements with a simple, non-risk-based "backstop" measure.

The Basel Committee is of the view that: a simple leverage ratio framework is critical and complementary to the risk-based capital framework; and a credible leverage ratio is one that ensures broad and adequate capture of both the on- and off-balance sheet sources of banks' leverage.

According to the document, public disclosure of the Basel III leverage ratio started becoming effective 1 January 2015 based on the standards published in January 2014 (the Basel III leverage ratio framework).

In January 2016, the Group of Central Bank Governors and Heads of Supervision (GHOS), the Committee's oversight body, discussed the final design and calibration of the Basel III leverage ratio.

The GHOS agreed that the Basel III leverage ratio should be based on a Tier 1 definition of capital and should comprise a minimum level of 3%, and further discussed additional requirements for global systemically important banks
(G-SIBs).

The GHOS also agreed to finalise the calibration of the Basel III leverage ratio in 2016 to allow sufficient time for it to be implemented as a Pillar 1 measure by 1 January 2018, thereby confirming the timeline set out in the Basel III framework.

The BCBS document proposes revisions to the design and calibration of the Basel III leverage ratio framework.

On revisions to the treatment of derivative exposures, the BCBS document said at present, the Basel III leverage ratio framework uses the Current Exposure Method (CEM) to measure the replacement cost (RC) and the potential future exposure (PFE) for derivative transactions, with certain leverage ratio-specific modifications to limit the recognition of collateral.

"This approach captures the exposure arising from the underlying derivative contract and counterparty credit risk (CCR) exposure."

However, when the Basel III leverage ratio framework was published in January
2014, the Committee noted that it would consider replacing the Basel III leverage ratio framework's use of the CEM with an alternative approach adopted under the risk-based framework.

In March 2014, the Committee published ‘The standardised approach for measuring counterparty credit risk exposures' (SA-CCR) to specify the measurement of derivative exposures for risk-based capital purposes in replacement of both the CEM and the Standardised Method (SM).

The Committee's main objectives in formulating the SA-CCR framework were to:

* devise an approach to measuring the CCR exposure of derivatives that is suitable to be applied to a wide variety of derivative transactions (margined and un-margined, as well as bilaterally and centrally cleared);

* addresses known deficiencies of the CEM and the SM;

* draws on prudential approaches already available in the Basel framework;

* minimises discretion to be used by national supervisors and banks; and

* improves the risk sensitivity of the risk-based capital framework without creating undue complexity.

"The identified deficiencies of the CEM that necessitated the development of the SA-CCR for the risk-based framework were that the CEM did not differentiate between margined and un-margined transactions; that the supervisory PFE add-on factors did not sufficiently capture the level of volatilities as observed over recent stress periods; and that the recognition of netting was too simplistic and not reflective of economically meaningful relationships between derivative positions."

According to the document, the Basel III leverage ratio framework lays out several general principles, among which is one that states that "banks must not take account of physical or financial collateral, guarantees or other credit risk mitigation techniques to reduce the [leverage ratio] exposure measure".

In addition, policy options for the Basel III leverage ratio must also be assessed in light of the rest of the Basel framework to ensure as much overall consistency as possible.

In balancing those criteria, the Committee proposes to implement a modified version of the SA-CCR to ensure consistency with these fundamental principles of the Basel III leverage ratio framework, especially with respect to not recognising collateral to reduce the leverage ratio exposure measure.

In particular, in the proposed modified version of the SA-CCR for the Basel III leverage ratio exposure measure:

(i) as was the case with the application of the CEM in the Basel III leverage ratio framework, the replacement cost (RC) component will continue to be modified to restrict the recognition of collateral by allowing only eligible cash variation margin (CVM) exchanged under the specified conditions set out in paragraph 25 of the Basel III leverage ratio framework as revised to act as an offset to the RC; and

(ii) the PFE add-on component will be adjusted by setting the PFE multiplier to 1 (one), thereby not recognising any collateral posted by the counterparty (or any negative net market value of the derivative position).

However, the Basel Committee said, in line with the SA-CCR framework, the effect of margining would continue to be reflected in the potential shorter time horizon or margin period of risk (MPOR), ranging between five and 20 days, depending on whether the transaction is margined and centrally cleared as well as on the size of the netting as set out in paragraph 164 of the SA-CCR framework.

The BCBS document noted that in a series of letters to the Committee, market participants have communicated a concern related to the treatment of initial margin (IM) posted by clients to banks serving on their behalf as clearing members (CMs) for centrally cleared client derivative transactions under the Basel III leverage ratio framework.

Market participants have stated that the current approach to capturing the PFE of a transaction with a client is excessive because collateral posted as IM by the client to the CM is not permitted to reduce the CM's PFE (whereas such a reduction is permitted under both the CEM and the SA-CCR as applied for risk-based capital purposes).

"Market participants have voiced concern that the Basel III leverage ratio treatment of client IM has the potential to adversely impact the ability of CMs to provide client clearing services, resulting in a potential outcome of increased concentration in the availability of client clearing, which could conflict with the G20 mandate to increase the use of central counterparty (CCP) clearing for derivatives that are sufficiently standardised and liquid as a means to mitigate systemic risk in derivatives markets."

The Committee said it is carefully considering this concern, adding that it is consulting on implementation of a modified version of the SA-CCR that does not allow any offsetting of a CM's PFE with the IM posted by its central clearing clients.

On the other hand, the maturity factor for client-cleared trades may be adjusted in line with the SA-CCR to take into account the shorter time horizons for margined trades, with the result that a five-day MPOR would apply to centrally cleared derivative transactions subject to daily margin agreements that CMs have with their clients.

"This approach can be viewed as internally consistent with the Basel III leverage ratio framework's principles and at the same time providing incentives to support the use of central clearing," it said.

In addition, in line with the risk-based framework, the Committee proposes to allow client servicing banks within multi-level client structures to exempt from their Basel III leverage ratio exposure measure the trade exposures to their CMs provided that the banks do not guarantee the performance of either their CMs or the qualifying central counterparties (QCCPs).

The Committee said it has decided that further evidence and data on the impact of the Basel III leverage ratio on client clearing and on CMs' business models should be collected during the consultation period, in light of the G20 mandate for central clearing.

The Committee will consider both the effects of the Basel III leverage ratio on the client clearing business model and the need for banks to have adequate capital to support their clearing activities in deciding whether to expand upon the measures described above, which may include permitting offsetting of a CM's PFE with the IM posted by clients on whose behalf it clears derivative transactions.

It further noted that the term "currency of settlement" in the criteria for eligible CVM in paragraph 25 (iii) in the January 2014 version of the Basel III leverage ratio framework has been cited as unclear in the context of multi-currency derivative contracts (e. g. foreign exchange swaps) and derivative contracts that are governed by master netting agreements (MNAs) and credit support annexes (CSAs), or by rules prescribed by CCPs.

Market participants have asked for clarification as to whether CVM payments would reduce derivative exposure amounts for purposes of the Basel III leverage ratio exposure measure when the payments are made in a currency or currencies identified in the legal documentation supporting a derivative transaction, such as a CSA or MNA.

In particular, banks may have numerous derivative contracts, which may be specified in different currencies of settlement for contractual payments with the same counterparty, which are governed by the same MNA.

The net amount under an MNA, determined utilising a spot FX conversion rate and expressed in a single currency, typically forms the basis for margin calls as well as for net settlement upon termination of the MNA.

A single daily margin payment may be owed under an MNA with respect to the net variation margin amount owed for all of the positions covered by the MNA, after completion of the netting process described above.

This single net margin payment, or payments equivalent to it, will be made in the currency or currencies identified in the CSA (or relevant collateral agreement) to the MNA.

There are also cases where the currency (or currencies) of the cash flows of individual derivative transactions is (are) different from both the termination currency of the MNA and the currency (or currencies) of the eligible collateral specified in the CSA (e. g. CVM is usually paid in the currency specified in the CSA), said BCBS.

In the current proposal, the Committee retains the wording "currency of settlement" to specify the eligibility of the currency in which CVM payments are made.

With specific reference to issues arising from foreign exchange risk, the Committee proposes that CVM be subject to an FX haircut where the currency of the CVM does not match the termination currency of the netting set (i. e. the currency in which the bank would submit its claim upon a counterparty default).

In its assessment, the Committee said it will consider the appropriateness of aligning the application of an FX haircut in the Basel III leverage ratio framework with the treatment as applied in the SA-CCR under the risk- based capital framework.

On revisions to the specific treatment for written credit derivatives, the Basel Committee noted that a bank that writes a credit derivative is exposed to the creditworthiness of the reference entity.

The Basel III leverage ratio framework treats written credit derivatives consistently with cash instruments (e. g. loans, bonds) and requires that the effective notional amount of written credit derivatives be included in the Basel III leverage ratio exposure measure, in addition to any associated CCR.

"The effective notional amount of written credit derivatives may be reduced by any negative fair value of those instruments that has reduced Tier 1 capital and by the effective notional amount of credit protection purchased through credit derivatives on the same reference name provided that the purchased credit derivatives meet the criteria set out in paragraph 30 of the January 2014 Basel III leverage ratio framework."

The Committee said it considers that a credit derivative purchased from a counterparty that is connected with the reference obligation or from a counterparty whose credit quality is highly correlated with the value of the reference obligation may not provide effective protection against the risks arising from a written credit derivative, and therefore proposes to introduce an additional criterion to prevent the offsetting eligibility of any protection subject to such wrong-way risk.

Additional revisions proposed by the Committee pertaining to written credit derivatives include clarifications regarding the meaning of the term "written credit derivative" and the option of partial reduction of the PFE of written credit derivatives where the effective notional (amount) is included in the Basel III leverage ratio exposure measure.

On the treatment of regular-way purchases and sales of financial assets, the Basel Committee acknowledged that the timing and method for recognising regular-way purchases or sales of financial assets that have not yet been settled differ across and within accounting frameworks.

Specifically, said BCBS, these trades may be accounted for either on the trade date (trade date accounting) or on the settlement date (settlement date accounting).

Furthermore, for trade date accounting, the offsetting of cash receivables and payables associated with sales and purchases of financial assets, respectively, is allowed under certain accounting frameworks, but disallowed under others.

The Committee therefore proposes to clarify the calculation of regular-way purchases and sales of financial assets for purposes of the Basel III leverage ratio exposure measure to ensure that differences in accounting frameworks do not affect the calculation among comparably situated banks, and that the Basel III leverage ratio exposure measure properly reflects the inherent leverage associated with these trades.

In this respect, the Committee notes that:

* in the case of financial asset purchases, a bank is exposed to the risk of a change in the value of the purchased assets as of the trade date, as well as to the cash or any other asset which will be the source of payment for the purchase until the settlement date; and

* in the case of financial asset sales, a bank is exposed to the risk that cash will not be delivered by the counter-party of the transaction to the bank to settle the transaction.

"This view of exposure for Basel III leverage ratio purposes is consistent in substance with a trade date approach to accounting for regular-way purchases and sales of financial assets, as the additive impact of the yet to be settled transaction (i. e. any associated exposure to the purchased assets or to the purchasing counterparty) is reflected on the bank's balance sheet from the time at which it enters into a transaction until the time at which the transaction settles."

In contrast, said BCBS, a settlement date accounting approach does not reflect on the balance sheet the risks associated with the assets purchased but not yet settled, nor with the cash receivables from assets pending settlement.

The Committee said that it is also aware that, under certain accounting frameworks, banks using trade date accounting that are active securities market-makers are allowed to offset cash receivables for unsettled regular- way sales of securities against cash payables for unsettled regular-way purchases of securities, and that this offsetting is unconditional (i. e. there are no restrictions on the counterparties, securities settled, settlement systems, etc).

"Given the transient nature of these transactions, the volatility in the amounts of securities that may be traded on a given day owing to market factors outside a bank's control, and the practice of using the cash received from securities sales to fund securities purchases, typically from the same set of counterparties, the Committee understands that this accounting treatment aims to minimise large day-to-day swings in market-makers' balance sheets, thus supporting their intermediation activity that provides liquidity to financial markets."

For these reasons, the Committee said it is considering two possible options for the treatment for measuring regular-way purchases and sales of financial assets for the purposes of the Basel III leverage ratio to ensure consistent measure of these exposures across banks regardless of the accounting framework used by a bank:

Option A

* Banks using settlement date accounting must treat unsettled financial asset purchases as off-balance sheet (OBS) items subject to a 100% credit conversion factor (CCF).

* Banks using trade date accounting must include the gross cash receivables owed that are attributable to sales of financial assets that are pending settlement. This implies that banks must reverse out any offsetting between cash receivables for unsettled sales and cash payables for unsettled purchases of financial assets that may be recognised under the applicable accounting framework.

Option B

* In addition to the criteria included in Option A, banks using trade date accounting may, subject to certain conditions, offset cash receivables and cash payables, with an equivalent effect to be permitted for banks using settlement date accounting.

The Committee has also proposed to revise the Basel III leverage ratio framework to provide clarification on: (i) whether general provisions may be deducted from the Basel III leverage ratio exposure measure; (ii) whether specific and general provisions may be deducted from OBS exposures and; (iii) the treatment of PVAs (prudent valuation adjustments).

The Committee further intends to allow both general and specific provisions that have decreased Tier 1 capital to reduce the Basel III leverage ratio exposure measure.

Similarly, it proposes that OBS items may be reduced by the amount of any associated specific and general provisions provided that they have decreased Tier 1 capital.

"In calculating OBS exposures under the Basel III leverage ratio framework, it is proposed that specific and general provisions be deducted from OBS exposures after the application of the relevant CCF."

In addition, to be consistent with the treatment of other deductions, the Committee proposes that PVAs for less liquid positions related to on-balance sheet assets and that are deducted from Tier 1 capital may also be deducted from the Basel III leverage ratio exposure measure.

On additional requirements for G-SIBs, the BCBS document noted that at its January 2016 meeting, the GHOS discussed additional Basel III leverage ratio requirements for G-SIBs, above the 3% minimum.

The Basel III framework has already introduced a higher risk-based capital ratio requirement for G-SIBs, it said.

The Committee believes that one way to maintain the relative roles of the risk-based ratio and the leverage ratio in the regulatory capital framework would be to introduce a higher Basel III leverage ratio requirement for G-SIBs.

"An additional leverage ratio requirement for G-SIBs could be based on the same Tier 1 definition of capital by which the Basel III leverage ratio minimum is measured."

The Committee said it seeks views on the relative merits of the following characteristics that would need to be specified for an additional G-SIB requirement:

* whether there should be a limit on Additional Tier 1 capital that may be used to satisfy an additional requirement;

* whether an additional requirement should be fixed and applied uniformly to all G-SIBs or should vary based on a scaling of the G-SIB's higher loss absorbency requirement as applicable under the risk-based framework; and

* whether an additional requirement should be in the form of a higher minimum requirement or a buffer requirement.

"The latter could operate in a manner analogous to the Basel III framework's risk-based capital ratio buffers (i. e. with restrictions on capital distributions if a G-SIB operates below the leverage ratio buffer) or as a buffer whereby supervisors would be expected to take timely and appropriate action in the event of a breach to ensure that the breach is temporary (i. e. without automatic restrictions on capital distributions)."

The BCBS document also addressed other issues including revisions to the credit conversion factors for off- balance sheet items, treatment of cash pooling transactions, treatment of traditional securitisations, treatment of securities financing transactions (SFTs), and disclosure requirements.

On the Basel III leverage ratio framework's treatment of cash pooling transactions, i. e. a treasury product offered to large corporate clients which allows corporate groups to combine the credit and debit positions of various accounts into one account, the Committee said that two different schemes can apply:

* Notional (or virtual) cash pooling combines the balances of several accounts of the entities within a corporate group in order to limit low balance or transaction fees without physical transfer of funds. Instead, balances of different entities are set off within the group, so that a bank charges interest on the group‘s net cash balance.

The Committee proposes that these balances be reported on a gross basis in line with revisions to paragraph 13 (paragraph 11 as revised) of the Basel III leverage ratio framework, which does not allow netting of assets and liabilities nor the recognition of credit risk mitigation techniques.

* Physical cash pooling, which combines various accounts from entities within a corporate group into a single master or concentration account at the end of each period through physical transfer of funds, typically by means of intra-day settlement.

The Committee proposes to allow banks to report those balances on a net basis if the transfer of credit and debit balances into a single account results in the balances being extinguished and transformed into a single balance (i. e. a single claim on or a single liability to a single legal entity on the basis of a single account) and the bank cannot be held liable in case of non-performance of one or multiple participants in the cash pool.

The proposal also requires such settlement to take place at least on a daily basis in order to be recognised on a net basis for the Basel III leverage ratio exposure measure, said BCBS. +