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Leverage ratio standard may understate systemic risk; attention to pledge collateral needed - IMF report

NEW YORK (Thomson Reuters Regulatory Intelligence) - Traditional bank-centric leverage metrics such as assets-to-capital tend to underestimate the full extent of leverage, as they fail to capture non-bank funding missing from balance-sheet data, an International Monetary Fund research paper suggested(here). This measurement gap means regulators could miss a build-up of systemic risk to dangerous levels.

The balance (scales) of Justice is seen outside France's national assembly in Paris October 16, 2008.

The paper suggests that properly accounting for pledged collateral transactions that are now left off the balance sheet would help capture a more accurate picture of leverage ratios and thereby risk build-up in the financial system.

“We believe that further efforts need to be made to adequately and systematically capture off-balance sheet items, especially pledged collateral transactions, in bank leverage metrics,” said the working paper by IMF researchers Manmohan Singh and Zohair Alam. The report was issued as a working paper intended to invite additional discussion.

“Policymakers and researchers interested in monitoring leverage and fully appreciating its impact on financial cycles and vulnerabilities would benefit from a deeper understanding of the links between banks with a global footprint, and their off-balance sheet funding from non-bank sources,” the report said.

Regulators use the leverage ratio standard as a complement of risk-weighted capital requirements, providing a safeguard against unsustainable levels of leverage build-up in the financial system. By considering all asset classes independent of their specific risk -- treating them equally risky-- the ratio mitigates gaming and model risk found in internal models and standardized risk measurement approaches. Internal models and standardized approaches may be subjective and susceptible to pro-cyclicality.

Within the framework of international Basel III capital standards, regulators have focused on increasing the traditional leverage ratio to 3 percent, with some jurisdictions such as the U.S. adopting more stringent standards with 5 percent.

LEVERAGE LURKING IN THE SHADOWS

The leverage ratio calculations have for the most part been based on balance-sheet items without considering the bank-nonbank nexus which makes up the bulk of the off-balance sheet financial transactions such as derivatives, securities lending, repo agreements, or prime brokerage activities.

Because expanding a bank’s balance sheet through on-balance sheet borrowing requires additional equity, banks have turned to various forms of off-balance sheet funding since the financial crisis. And regulators have so far been struggling to measure such funding as compiling data has been challenging.

Recently international regulatory bodies made efforts to address this.

The global shadow banking monitoring report(here) by the Financial Stability Board ("FSB") has included non-banks' balance-sheet data, including their involvement in credit intermediation, therefore quantifying to some extent the systemic risk they pose in the form of increased leverage in the financial system. The report, however, relies on aggregate balance sheet data, without being able to specifically account for the size of the nonbank funding to banks.

The Bank of International Settlements ("BIS") has offered revisions(www.bis.org/bcbs/publ/d424.htm) that modify the leverage ratio to allow off-balance sheet items such as derivatives and securities financing transactions to be accounted for the bank's asset exposure amount for leverage calculations. While this is an improvement and that captures both the on and off-balance sheet sources on a national level, it still leaves out cross-border transactions, which are harder to track.

PLEDGED COLLATERAL AS KEY SOURCE

Enter the pledged collateral market.

The authors of the IMF paper have been compiling data on pledged collateral – the largest off-balance sheet component for the largest banks -- and wealth management accounts from dealer balance sheets to monitor cross-border funding activities.

Data is not readily available. In most cases, authors have to piece together bits from various sources ranging from footnotes to information obtained from investor relation offices.

The report’s findings reveal that balance sheets for the largest 15 “globally significant international banks”, or G-SIBs -- have mostly been declining in size. The exceptions are JPMorgan, Bank of America, and Nomura, partly due to their purchase of Bear Sterns, Merrill Lynch, and certain business lines of Lehman respectively. Concurrently, most of these G-SIBs’ off-balance sheet funding as a share of total funding is higher now than in 2007.

Another critical finding is that most of the pledged collateral never makes it to the balance sheet. While current accounting standards force banks to bring secured financing assets on-balance sheets, certain type of transactions that involve exchange of securities-for-securities --where no cash is exchanged-- are allowed to be held off-balance sheet.

To provide perspective on how this underestimates the leverage ratio, consider the example of Barclays. In 2016, the bank’s total pledged collateral was £466 billion, only £34 of which made its way onto the balance sheet. While the bank’s leverage ratio was 20.7 percent (based on balance sheet data alone) for reporting purposes, this would increase to over 28 percent if its pledged collateral transactions were fully recorded.

The authors say accounting for pledged collateral transactions along with other off-balance sheet instruments in cross border transactions would be a key step towards capturing a more accurate picture of leverage ratio and systemic risk build-up.

Gathering such information and developing databases on off-balance sheet transactions can augment the leverage data at a national level with an additional “cross-border leverage” metric. This could help policymakers perceive financial cycles earlier and more accurately, allowing them to better apply policy options in a timely fashion.

“Fully accounting for pledged collateral transactions could increase bank leverage values by about a third at the GSIB level,” the report said. “While accounting for pledged collateral does not allow us to fully measure the interconnectedness within the financial system, it nevertheless provides useful trends, and opens an avenue for research.”

(Bora Yagiz, FRM is a New York-based Regulatory Intelligence Expert for Thomson Reuters Regulatory Intelligence, specializing in risk. Email Bora at bora.yagiz@thomsonreuters.com)

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