Leveraging Technology for the Leverage Ratio

An increasing number of financial institutions are leveraging modern technologies to manage regulatory change more efficiently and reduce costs. This article discusses the proposed changes to the UK’s leverage ratio framework and the affect on firms.

The UK’s leverage ratio framework

Originally posted here by UK Finance.

Authors:
Dr Maximilian Dyck, Paralegal, Suade Labs ([email protected])
Charlie Quarterman, Head of Partnerships, Suade Labs ([email protected])

On 29 June 2021, the Prudential Regulation Authority (PRA) and the Financial Policy Committee (FPC) published a joint consultation paper (CP14/21) proposing changes to the UK’s leverage ratio framework. With the passing into law of the Financial Services Act in April 2021, the PRA’s powers in relation to the leverage ratio framework have been extended to the extent that the leverage ratio calculations are now part of the PRA’s responsibilities. To ensure any macroprudential concerns are appropriately addressed, the FPC makes several recommendations and directions regarding the remit of the leverage ratio framework and the calculation of the leverage exposure measure which the PRA proposes to implement. The proposals mean that the UK regulatory system will stay aligned with the Basel standards adopted across the globe. UK Finance note that its members broadly support the endeavour to maintain international alignment.

Leverage ratio remit

The FPC has proposed to amend the UK’s 3.25% leverage ratio framework by expanding its remit to include a wider range of financial institutions. Under the proposals, the leverage ratio framework will apply to all UK banks, building societies, and investment firms with holdings of significant non-UK assets as well as to holding companies designated or approved by the PRA with consolidated situations comparable to any other relevant firms. This brings important FPC macroprudential policies to a wider range of relevant firms. The leverage ratio complements the risk-weighted capital measure by providing additional protection.

Where firms would incur disproportionate costs from applying the leverage ratio at the individual level, the PRA may choose to apply the leverage ratio on a sub-consolidated level. This would benefit firms with several subsidiaries where applying the leverage ratio for each individual subsidiary would result in higher costs. The FPC and PRA proposals represent an interesting balance between expanding the remit of the leverage ratio framework and ensuring firms do not incur excessive costs.

Leverage exposure measure

For the leverage exposure measure (LEM), the PRA proposes a number of amendments to ensure the LEM falls in line with international developments. These include the creation of a single LEM, the application of the SA-CCR (standardised approach to counterparty credit risk), allowing deductions for loan-loss reserves, and permitting netting of cash payables and receivables in securities financing transactions (SFTs). The creation of a single LEM should significantly simplify processes for relevant firms, whilst the SA-CCR, deductions of loan-loss reserves, and netting in SFTs mitigates the impact of the LEM on firms.

The leverage ratio is fundamentally designed to ensure that firms hold enough capital against a nominal value for their exposure measure. The minimum capital ratio uses a risk-weighting approach to ensure the riskiness of a firm’s activities is reflected in its capital ratios. The SA-CCR improves the risk sensitivity of the exposure measure in derivatives transactions to netting, collateralisation, and hedging. Where applying the nominal value may have required high capital holdings against derivatives exposures under the leverage ratio, applying the SA-CCR to derivatives transactions for the LEM should mitigate this. Similarly, deducting loan-loss reserves that have reduced tier 1 capital and permitting netting of cash payables and receivables in SFTs should achieve a good balance in the leverage ratio between offering additional protection and avoiding undue restrictions of firms’ activities.

Reporting

The PRA proposes the creation of a single, harmonised set of leverage ratio reporting templates to be submitted by all firms. Reports will occur at the individual, consolidated or sub-consolidated level depending on each firm’s individual situation. All firms will need to report their leverage ratios both inclusive and exclusive of central bank reserves as well as inclusive and exclusive of transitional measures concerning the capital measure of the leverage ratio. Reports will need to be submitted on a quarterly basis with a remittance of 42 calendar days. This will ensure that the leverage ratio reporting obligations fall in line with the proposed timelines for quarterly reporting for non-leverage information. The reporting timelines would be 31 March, 30 June, 30 September, and 31 December.

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