If U.K. Can Make Leverage Ratio Changes, Why Can't U.S.?

WASHINGTON — U.S. banks are applauding a move by the Bank of England to exempt excess reserves from consideration as part of the country's leverage-based capital rules in hopes that the Federal Reserve and other domestic regulators might follow suit.

The Bank of England's Financial Policy Committee on Thursday recommended that the Prudential Regulatory Authority allow banks to exclude excess reserves on deposit with the central bank as part of their total assets in the calculation of the leverage ratio. The agency argued that reserves kept at the central bank hold as little risk as possible and therefore the change would not affect financial stability.

Industry representatives in the U.S. agreed, using the U.K. agency's conclusions to bolster their own calls to make the same change here.

"It's kind of a wasted piece of the leverage calculation," said Wayne Abernathy, executive vice president of financial institutions policy and regulatory affairs at the American Bankers Association. "Maybe that sends a message to the Fed that in calculation of our leverage ratio, that's something they ought to try. I think it would be a wise thing."

William Nelson, executive managing director and chief economist at the Clearing House Association, said that the policy of including excess reserves is widespread — it's baked into the leverage ratio calculation framework in the Basel accords themselves. Banks have been criticizing that for years and the Clearing House is slated to publish a research note shortly outlining that and other shortcomings in the leverage ratio calculation method.

"Banks have been eager for the banking agencies to exclude reserve balances from the calculation of the leverage ratio," Nelson said. "The idea that banks should hold capital against deposits at the central bank — which are as riskless an asset as exits — is bad public policy. That's capital that could be freed up and used elsewhere."

Karen Shaw Petrou, managing partner at Federal Financial Analytics, said the change in the U.K. treatment of reserves might turn heads among bank regulators, who understand the banks' concerns but have kept the calculations as they are for practical and political reasons. On the one hand, the Fed's payment of interest on excess reserves has been the subject of criticism from lawmakers from both political parties, and House Democrats only recently joined with Fed Chair Janet Yellen in her defense of the policy.

"The politics are really the problem," Petrou said. "I don't think the Fed denies the logic of removing excess reserves. Once they start taking one thing out, does the whole edifice fall out? The leverage ratio is fundamentally illogical in many ways — it has a lot of perverse consequences."

The U.K. said the change makes sense because excess reserves are unique assets.

"An increase in central bank claims does not typically expose a firm to additional risks, if matched by deposits in the same currency: as the ultimate settlement asset, central bank claims are a unique asset class," the Prudential Regulatory Authority said in a statement announcing the change. "To that end, the exclusion of such central bank claims from the total exposure measure would not adversely impact the PRA's safety and soundness objective."

The statement went on to say that to the extent that the change might reduce banks' overall capital requirements, U.K. regulators will begin a more thorough examination of the rules in 2017 to recalibrate and offset the difference made by excluding excess reserves.

"Excluding current central bank reserves from the exposure measure — the denominator of the leverage ratio — mechanically reduces the nominal amount of capital required to meet the leverage ratio standard, other things equal," the PRA said. "This is not the FPC's intention. It therefore intends to recalibrate the UK leverage ratio standard to offset this impact."

The Fed, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp. declined to comment on the changes at the Bank of England. But there are reasons to expect that those agencies may be skeptical of the banks' calls to make similar changes.

The agencies completed a final rule in late 2014 modifying the denominator calculation method for the so-called "advanced approaches" banks — that is, those with more than $250 billion in U.S. assets and more than $10 billion in foreign assets. Fed Gov. Daniel Tarullo said at the time that those changes "will result in a more appropriately measured set of leverage capital requirements and, in the aggregate, are expected to modestly increase the stringency of these requirements across the covered banking organizations."

The Bank of England was also reacting to a serious and proximate macroeconomic danger in its midst — namely the country's vote in June to split off from the European Union, an event that sent shockwaves across the global financial world and that is widely expected to drag down the U.K.'s economy in coming months and years. Whether the Fed feels similar macroeconomic pressure is less clear.

But Nelson said there appears to be a growing sense among regulators and central banks in the largest global economies that the recession — and particularly the effect that post-crisis monetary policy actions have had on central bank balance sheets — may spur regulators in the U.S. to think twice about their treatment of excess reserves.

"The U.S., the U.K., the [European Central Bank] and [Bank of Japan] are all using extraordinary monetary policy actions that increase the reserve balances of banks tremendously, so I think there is a lot of sympathy around the world for the idea that requiring banks to hold capital against those reserve balances is an unwarranted tightening of bank regulation that will slow growth," Nelson said. "I don't think it's unprecedented to support adjustment of an international standard based on input from abroad."