Banks Brace for Even Tougher Leverage Ratio

WASHINGTON — Regulators are expected to stick close to their original plan to establish how much the biggest banks are allowed to borrow against their total balance sheets when they issue a final rule on Tuesday.

But that doesn't mean there isn't room for a significant twist.

The Federal Reserve Board and Federal Deposit Insurance Corp. are set to vote on a final rule establishing a tougher leverage ratio for the largest banks (the Office of the Comptroller of the Currency is expected to release it shortly thereafter). Yet at the same time, the agencies will also consider a proposal that could eventually make a critical change to how that ratio is calculated.

The uncertainty underlines the evolutionary process that Basel III has become, with regulators finalizing one key part of the plan even while they simultaneously contemplate a major alteration.

"It's one of the consequences of rulemaking in a piecemeal fashion," said Andrew Fei, an associate at Davis Polk & Wardwell. "The regulators are under pressure to finalize the enhanced leverage ratio. They want to finalize something to send a policy message and then work on technical aspects of the denominator. As a result, whatever level they set the enhanced leverage ratio on Tuesday, they should — at least in theory — re-evaluate that level when they finalize the denominator taking into account any changes to the denominator."

At issue is the leverage ratio for the eight largest banks, including Citigroup, JPMorgan Chase, Bank of America and Wells Fargo.

Under Basel III, all institutions must meet a 4% leverage ratio, but the final rule regulators issue Tuesday will detail a supplemental ratio that goes further. Regulators proposed it last summer in response to both pressure and criticism by top FDIC officials that the 3% minimum included in the Basel III package of capital and liquidity rules would be insufficient to curb the risks seen prior to the financial crisis.

In their proposal, regulators suggested a 5% ratio for bank holding companies and 6% for their insured subsidiaries.

Most observers estimate the final numbers will hit those marks.

"Our expectation is that the leverage rule will be adopted largely as proposed," Jaret Seiberg, an analyst at Guggenheim Securities, wrote in a research note last week. "That means the odds favor cash, excess reserves held at the Federal Reserve, and Treasury securities counting toward the leverage ratio."

But the complicating factor comes in what the agencies may do next. On the same day, regulators plan to issue a new proposal that would incorporate changes made in January by the Basel Committee on Banking Supervision to a global leverage standard.

Those adjustments will ultimately have an impact on the denominator of the leverage ratio. The changes will automatically apply to the basic leverage ratio all banks already face, but an open question remains whether regulators will also implement the different denominator to the supplemental leverage ratio as well.

Most observers expect regulators to ultimately apply the same standards for both leverage ratios.

"I believe the agencies for consistency sake will want the denominator across the board to be the same and they will finalize the enhanced one leaving open the change to the denominator once they determine what they are going to do," said Karen Shaw Petrou, a managing partner at Federal Financial Analytics.

The changes proposed by the Basel Committee earlier this year included ensuring exposure requirements adequately reflected the economic realities tied to certain transactions that banks regularly engage in, such as the clearing of derivatives a bank does on behalf of a customer.

But any changes to the denominator would impact the heft of the overall ratio, potentially making a 5% leverage requirement for holding companies much more stringent. As more assets are brought into the definition of the denominator, the stricter the requirement.

"I don't think anyone is expecting any changes in the required ratio," said Susan Krause Bell, a managing director at Promontory Financial and a former OCC official. "The largest banks will have to hold 5%, and by the end of the day, they have to figure out the denominator measure, and that's what makes it a tougher requirement."

There are some that suggest regulators could signal they might revisit the leverage ratio following the now-pending rulemaking, but the more likely scenario is for regulators to stick to the 5% and 6% ratios, given the ongoing political pressure.

"They've set their mind on a particular leverage ratio surcharge," Fei said. "They may revisit based on future revisions to the denominator, but based on their track record of setting U.S. standards that are super-equivalent to Basel, it'll likely be a one-way ratchet. Politically it would be difficult for regulators to lower ratios after raising them."

Some in the industry also speculate that regulators could proceed on Tuesday with incorporating changes into the denominator for the enhanced leverage ratio, but some observers disagree.

"They'll proceed in a more deliberate fashion," Petrou said. "Propose the denominator; finalize it, and then change the enhanced supplementary to conform to it, once they've done it. It's a gradual process leading to a very stringent capital rule."

Banks have been deeply concerned the plans by the regulators will be at cross-purposes with other requirements, such as a new liquidity requirement, which requires banks to hold a buffer of high-quality liquid assets against expected stress outflows over a 30-day period.

A higher — and potentially binding — leverage ratio would wind up creating pressure on banks to shed liquid assets above the minimum required under the liquidity rule and encourage banks to curtail activities that put liquid assets on their balance sheets.

"There's a real risk here," said Oliver Ireland, a partner at Morrison & Foerster and former associate general counsel at the Fed. "On one level, you're restructuring the market in ways that people don't understand or you're restricting banks' balance sheets in a way that people don't understand."

The Fed has disputed such critiques, arguing that the liquidity requirement would set up a floor that would effectively establish a minimum of high-quality liquid assets that banks would have to hold. Fed officials have said that would negate any incentive for a firm to reduce the amount of high-quality liquid assets it would hold as a result of the leverage ratio.