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Wednesday, 18 October 2017

Caught out by leverage

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Some of the world’s biggest banks – including Deutsche Bank and Barclays – completely misjudged regulators’ determination to clamp down on leverage. Many were forced into panic overhauls, even though the shift had been well flagged for almost three years.

It was scheduled to be a run-of-the-mill earnings day on an otherwise normal Tuesday in mid-summer. But over just 45 minutes on the morning of July 30 2013, the long-standing business model of two of Europe’s banking behemoths was very publicly ditched.

Deutsche Bank was first, at 6.17am. Buried in its earnings release was the announcement that, despite a clear-out in which it had moved €122bn into a non-core unit just seven months earlier, the firm would need to shed a further €300bn of assets – a whopping 16% of its entire balance sheet. The impact to earnings would be in the hundreds of millions, even when the figure was later moderated to €250bn.

Investors were digesting that news when Barclays came out at 7.02am with its own bombshell. The UK bank would be raising £5.95bn in a surprise rights issue and launching another review of its entire business. Five months after setting out a “new course” for itself, it was back to the drawing board.

These two were the first of a number of firms to be wrong-footed by what banks characterised as an unexpected clampdown on leverage, after the Basel Committee on Banking Supervision outlined in June how it would implement a 2010 international agreement on the measure.

Banks had spent the previous few years lobbying for the proposals to be watered down, and in particular for the Basel Committee to measure leverage against risk-weighted assets. When it ignored these pleas and opted for a more onerous measure, Deutsche, Barclays and others were forced to frantically redraw their plans.

“There’s no doubt that the fixed-income division is being run through a set of metrics now that are different from the metrics we had 12 months or 24 months ago,” Deutsche co-chief executive Anshu Jain said a few weeks later, admitting in effect that the bank had misjudged what was about to happen.

Since then, banks have sought to portray the Basel June announcement as a betrayal, an about-turn that could cost them billions in lost profit over the coming years. But the reality is more nuanced. In fact, the shift was flagged three years earlier. Banks – perhaps foolishly – believed their lobbying would head off the moves.

Simple and straightforward

The two-page section in the 2010 Basel agreement made it clear that the leverage ratio should be “simple, transparent, non-risk based” and include off-balance sheet exposures. Regulators say banks should therefore not have been surprised the Committee chose to measure leverage as Core Tier 1 capital as a percentage of total exposure – rather than the risk-weighted measure pushed by banks.

“It was pretty clear from the 2010 agreement that the rules were intended to be fairly simple and straightforward in their nature,” said Wayne Byres, secretary general of the Basel Committee on Banking Supervision. “We wanted to stick to that simplicity.”

According to Byres, the Committee spent the intervening three years doing input studies, collecting data from banks and analysing the impact. With a 3% leverage ratio already committed to in 2010, regulators had to ensure the rule would have some bite and prevent a releveraging of the banking system – hence a reluctance to dilute the proposals despite lobbying efforts from banks.

“The ratio puts a constraint on the industry by placing a simple floor as a backstop to the risk-based measure,” said Byres, referring to the system that banks had been using for two decades to calculate the amount of capital they needed. “One of the shortcomings of the risk-based approach was that it doesn’t always put an absolute constraint on leverage, and regulators had become increasingly concerned about that.”

During the gap between the initial document and the June publication of the Basel proposals, concerns were growing among regulators that the risk-based capital approach of Basel II had not been enough to prevent banks becoming overleveraged, meaning that the risks of a sudden deleveraging – as happened in late 2008 – and downward spiral of prices and deep losses were still elevated.

Banks had also become bigger than ever during the period the rules were being drawn up. Despite the initial deleveraging in late 2008, by 2013 many banks had reached new records in terms of total assets. Regulators were concerned that risk-based capital measures, in particular banks’ own internal ratings-based models, were not acting as a brake on balance sheets. A study into IRB models had also discovered huge variations in banks’ own calculations of required capital for the exact same assets.

Political pressure

At the same time, political pressure was growing in some countries to go even further than the 2010 internationally-agreed proposals, amid concerns that governments just could not afford to bail out banking systems again.

In the US, in particular, there was a growing faction of lawmakers keen to clamp down on leverage. Jeb Hensarling, who headed the House Financial Services Committee, said he favoured a shift away from the global risk-based approach, which had failed to prevent the financial crisis in 2008. Among lawmakers, talk was growing of a leverage ratio of as much as 15%. Regulators were growing uneasy about the direction of the political discourse, fearful that if left unchecked it could cause more harm than good. While still waiting on the Basel decision, and under pressure to excessively tighten already existing US laws on leverage, supervisors in Washington DC felt the need to act.

“There was a synchronisation issue between rulemaking at the Basel level and on an individual country basis,” said one US regulator. “There was public pressure to make the leverage ratio much higher in the US and we realised that it was important to form the debate rather than just be a participant. There was a concern that too high a ratio would hinder US banks’ ability to compete overseas.”

By April 2013, it looked like regulators had fought off the congressional push for a leverage ratio of up to 15%. The issue was settled in July, when the Federal Reserve, Federal Deposit Insurance Corporation and Office of the Comptroller of the Currency revealed US rules for a 4% leverage ratio – and up to 6% for larger banks.

The UK and Switzerland have also, like the US, unveiled additional leverage rules that will supplement the Basel measure, which was out for consultation until September and is now being finalised. It is perhaps no surprise that the countries implementing supplemental rules are the ones which had to bail out their banking systems. Byres said such moves did not change things for the Committee.

“If jurisdictions feel they want to get there faster, or have additional requirements to the Basel rules, then that is not an issue for the Basel Committee,” he said. “Some jurisdictions are doing exactly that, and see early compliance as a virtue.”

With some countries feeling the Basel rules are not enough, the Committee is likely to find it difficult to ratchet down the rules – despite the 59 responses mostly asking for some dilution, it received in response to the June consultation.

To see the full digital edition of the IFR Review of the Year, please click here.

To purchase printed copies or a PDF of this report, please email gloria.balbastro@thomsonreuters.com

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