On April 8, 2014, the Federal Reserve Board (FRB), the Office of the Comptroller of the Currency (OCC), and the Federal Deposit Insurance Corporation (FDIC and, collectively, the "Agencies") approved a final rule (the “2014 Rule”) that effectively requires the nation's eight largest bank holding companies and their subsidiary banks to maintain an enhanced supplementary leverage ratio (eSLR).
The eSLR requirement builds on an existing rule that bank holding companies and their subsidiary banks that use the advanced approaches method to determine risk-based capital maintain a 3 percent supplementary leverage ratio (SLR) in addition to the 4 percent requirement for banking organizations generally. The eSLR standard for the covered bank holding companies is marginally more than two percentage points above the SLR requirement, while the standard for the subsidiary banks is 3 percent above the SLR requirement. In both cases, the eSLR standard is not technically mandatory – a covered institution can remain adequately capitalized even if it does not satisfy the eSLR standard – but the benefits of meeting the eSLR standard are sufficiently great to render the standard a practical requirement.
The Agencies also proposed on April 8 a rule that would revise the denominator used to calculate the SLR and the eSLR (the "2014 Proposal"). The changes in the 2014 Proposal, which implement changes to the leverage ratio recently approved by the Basel Committee on Banking Supervision (BCBS), would make the SLR and the eSLR more stringent measures of leverage than the general tier 1 leverage requirement that applies to nearly all U.S. banking holding companies and banks.
The final rule will take effect on January 1, 2018, but the institutions subject to the eSLR standard must begin reporting the ratio in 2015. The SLR standard has the same timing requirements. The proposed rule, if finalized, would also take effect in 2018. Comments on the proposed rule are due by June 13, 2014.
We review below the SLR, the new eSLR, and the proposed denominator for both measurements.
Leverage Ratios in the 2013 Rule
The Basel III-based regulatory capital rules issued in July 2013 (the "2013 Rule") largely confirmed the existing tier 1 leverage requirements for banking organizations, but a few points are worth noting.
Banking organizations have for some time been subject to a leverage requirement of 4 percent although banks and bank holding companies with, respectively, composite CAMELS or BOPEC ratings of 1 have been required to meet a leverage measure of only 3 percent. As a practical matter, all banks seek to and most banks do hold leverage capital of more than 5 percent, since that level has long been required for well capitalized status under the prompt corrective action regime. The general leverage capital ratio is the ratio of tier 1 capital to average consolidated assets less any amounts deducted from tier 1.
The 2013 Rule revised the existing standards in two respects. First, the 3 percent exception was eliminated; all banking organizations were required to hold at least 4 percent leverage capital, regardless of composite CAMELS or BOPEC ratings. Second, while the nominal ratio remained the same, the 2013 Rules narrowed the definition of tier 1 capital, which reduced the ratios for banking organizations that rely on forms of capital other than common equity. Cumulative preferred stock, for example, no longer qualifies as tier 1 capital.
Separately, and most notably, the 2013 Rule imposed SLR standards for bank holding companies and their subsidiary banks that use the advanced approaches method to calculate risk-based capital. The SLR standard for these bank holding companies is 3 percent – meaning that all advanced approaches bank holding companies must maintain a leverage ratio of 7 percent. For advanced approaches banks, the SLR requirement is 3 percent as well and serves as the threshold for adequately capitalized status under the prompt corrective action regime. An advanced approaches bank with a leverage ratio below 7 percent accordingly is subject to the various sanctions and requirements that apply to an undercapitalized insured depository institution.
The 2013 Rule also introduced a new denominator for the SLR, “total leverage exposure,” that is different from and more expansive than the denominator used for the general leverage capital ratio. As a result, the SLR standard as a practical matter requires more than 3 percent additional capital in relation to the leverage capital required by the general leverage regulation. Off-balance sheet exposures now must be taken into account in determining the sufficiency of the leverage capital of an advanced approaches banking organization. Total leverage exposure under the 2013 Rule is the sum of:
- The balance sheet carrying value of all on-balance sheet assets (including any carrying values of derivative contracts on the balance sheet), less any amounts deducted from tier 1 capital;
- The potential future credit exposure (PFE) amount for each derivative contract to which the banking organization is a counterparty (or each single-product netting set of such transactions), determined in accordance with the treatment of derivative contracts under the standardized approach for risk-weighted assets. Total leverage exposure does not, however, recognize any credit mitigation effect of collateral;
- 10 percent of the notional amount of unconditionally cancellable commitments made by the banking organization; and
- The notional amount of all other off-balance sheet exposures of the banking organization, excluding most repo-style transactions and unconditionally cancellable commitments. "Repo-style transactions" is a term that covers repurchase and reverse repurchase agreements and securities borrowing and lending transactions (subject to various provisions).
This denominator is the simple arithmetic mean of the ratio calculated as of the last day of each month in a calendar quarter. By contrast, the denominator in the general leverage rule is the average of total consolidated assets at the close of business of either each day in a quarter or each Wednesday in the quarter.
The 2014 Rule
The 2013 Rule was accompanied by a proposal for two eSLRs: (i) an extra 2 percent (really, just over 2 percent) for bank holding companies with more than $700 billion in total consolidated assets or $10 trillion in assets held in custody (referred to here as "covered bank holding companies") that wish to make distributions or pay discretionary bonuses out of eligible retained income without limitation (other than the amount of eligible retained income); and (ii) an extra 3 percent for their subsidiary banks (referred to here as “covered banks") that wish to be treated as well capitalized for prompt corrective action purposes. The 2014 Rule largely adopts this proposal and is in turn accompanied by another proposal that would modify the denominator of the SLR that was described in the 2013 Rule.
To be more specific: under the rules for distributions and discretionary bonus payments, a covered bank holding company, will, beginning in 2018, be limited in the amounts it can pay out of eligible retained income unless the company maintains an eSLR that is just over 2 percent higher than the SLR in the 2013 Rule. (If the eSLR is exactly 2 percent, then restrictions still apply.) However, unlike the SLR, the eSLR does not determine overall capital adequacy; a covered bank holding company is adequately capitalized so long as it satisfies the SLR requirement and regardless of its eSLR. In any case, a covered bank holding company would, in order to satisfy its shareholders, need to meet the eSLR standard. As a result, the additional leverage capital standard for the covered company is now just over 5 percent. With this amount added to the 4 percent general leverage requirement, a covered bank holding company will have to hold total leverage capital of slightly above 9 percent.
The eSLR for covered banks functions as a requirement in a similar way. Under the SLR requirement in the 2013 Rule, these banks, beginning in 2018, must maintain leverage capital 3 percent above the general 4 percent standard in order to be deemed adequately capitalized for prompt corrective action purposes. A leverage ratio below 7 percent at one of these banks would cause the bank's primary federal regulator to require a capital restoration plan and impose limits on the bank's operations. The 2014 Rule requires a covered bank – if it wishes to maintain well capitalized status under the prompt corrective action rules – to hold 6 percent of leverage capital in addition to the 5 percent that is required of all other well capitalized banks. A covered bank thus can still qualify as adequately capitalized with a 7 percent leverage ratio and avoid any limitations associated with undercapitalized status, but a banking organization will not qualify for the advantages that accrue to well capitalized subsidiary banks until the bank's leverage ratio reaches 11 percent. For example, a covered bank holding company that has elected financial holding company status and engages in nonbank financial activities must maintain the well capitalized status of its subsidiary bank, and its nonbank activities will be in jeopardy if it does not.
The 2014 Rule does not change the method in the 2013 Rule of calculating the SLR, and the same method applies to the eSLR. As described above, this method is different from that used to determine the general leverage standard. The general standard is the ratio of tier 1 capital to total on-balance sheet assets and is reported quarterly using the average of total assets at the close of business of either each day in a calendar quarter or each Wednesday in the quarter. The SLR and eSLR are, by contrast, the arithmetic means of the ratio of tier 1 capital to the sum of total on-balance sheet assets and certain off-balance sheet assets as determined on the last day of each of the three months in a calendar quarter.
The 2014 Proposal
The SLR standard that is set forth in the 2013 Rule is based on the leverage requirements that the BCBS included in the Basel III framework in 2010 and 2011. Shortly before the Agencies finalized the 2013 Rule, the BCBS proposed a set of changes to the leverage ratio. The BCBS then finalized those changes in January 2014. The 2014 Proposal is intended to implement these changes. If finalized, these changes will take effect in 2018 although they would be reflected in reports that the advanced approaches organizations must file beginning in 2015.
The 2014 Proposal would modify the SLR denominator in several respects. Recall that the 2013 Rule requires that the SLR denominator include three elements not on the balance sheet: (i) credit exposures associated with uncollateralized derivatives, (ii) 10 percent of the notional amount of unconditionally cancellable commitments, and (iii) the notional amount of all other off-balance sheet items, other than repo-style transactions and uncancellable commitments (which are dealt with elsewhere).
The 2014 Proposal would continue to require that the first two sets of off-balance sheet assets, as described above, be included in the denominator. The proposal would, however, replace the third set of off-balance sheet items in the denominator (the notional amount of other off-balance sheet exposures, excluding repo-style transactions) with a more complex analysis, including specific classes of off-balance sheet assets. If finalized, the 2014 Proposal is likely to produce a total leverage exposure that is greater than that described in the 2013 Rule, but the effects may vary among institutions. The proposal would treat credit derivatives more stringently than does the 2013 Rule, but it also introduces calibrated credit conversion factors that would reduce the impact of certain off-balance sheet assets on total leverage exposure. The proposed changes include the following:
Cash Variation Margin
The carrying value of derivative contracts on the balance sheet is a function of the mark-to-fair value of the contract. If the mark-to-fair value is positive, a banking organization could, under GAAP, deduct from this amount the amount of any cash collateral received from a counterparty and conversely could offset any negative mark-to-fair value with the amount of cash collateral posted to a counterparty.
- The favorable effect of a cash collateral offset is available to an institution only if the collateral satisfies the following five prerequisites:
- For derivative contracts that are not cleared through a qualifying central counterparty, the cash collateral received by the recipient counterparty is not segregated;
- Variation margin is calculated and transferred on a daily basis based on the mark-to-fair value of the derivative contract;
- The variation margin transferred under the derivative contract or the governing rules for a cleared transaction is the full amount that is necessary to fully extinguish the current credit exposure amount to the counterparty of the derivative contract, subject to any required threshold and minimum transfer amounts;
- The variation margin is in the form of cash in the same currency as the currency of settlement set forth in the derivative contract. Currency of settlement means any currency for settlement specified in the qualifying master netting agreement, the credit support annex to the qualifying master netting agreement, or in the governing rules for a cleared transaction; and
- The derivative contract and the variation margin are covered by a qualifying master netting agreement or by the governing rules for cleared transactions.
Eligible cash collateral can reduce only current credit exposure amounts but not the PFE.
The credit risk associated with a credit derivative is in large part the credit risk of the reference exposure, rather than that of the counterparty. The 2013 Rules, however, took account only of the credit risk of the counterparty. The 2014 Proposal would incorporate the credit risk of the reference exposure. The SLR denominator would include the effective notional amount of all forms of sold credit protection, including credit default swaps and total return swaps that reference assets with credit risk. Any multiplier in the derivative contract would apply. A banking organization subject to the SLR requirement could reduce the amount of the sold credit protection (for the purpose of the SLR denominator) by any or all of four amounts, as follows:
- Any reduction in the mark-to-fair value of the sold credit protection that is recognized in common equity tier 1 capital.
- The effective notional principal amount of any purchased credit protection that references a single exposure, provided that (i) the remaining maturity of the purchased protection is greater than that of the sold protection; and (ii) the reference exposure of the purchased protection refers to the same legal entity as the sold protection and ranks pari passu with or is junior to the reference exposure of the sold credit protection.
- For purchased credit protection that references multiple exposures, the effective notional principal amount if the purchased protection is economically equivalent to buying credit protection separately on each of the individual reference exposures of the sold credit protection. For example, a bank could purchase protection on an entire securitization structure or on an entire index. Purchased credit protection would be required to cover all of the sold credit protection's reference exposures.
- If the sold credit protection references more than one exposure, the reference exposures of the purchased credit protection, if all of the reference exposures and the level of subordination of the purchased protection is identical to that of the sold protection.
The benefits of purchased credit protection may not be fully available in all situations, however. For example, if a banking organization reduces the effective notional principal amount of sold credit protection, the bank would be required to reduce the effective notional principal amount of purchased credit protection by the amount of any increase in the mark-to-fair value of any purchased credit protection that is recognized in common equity tier 1 capital. Separately, a banking organization could not use the effective notional principal amount of purchased credit protection to reduce the effective notional principal amount of sold credit protection if the organization purchased the credit protection through a total return swap and did not appropriately record the deterioration in the mark-to-fair value of the sold credit protection. To avoid double-counting, a banking organization would be able to reduce the amount of the PFE of a derivative contract (which is held on balance sheet) by the amount of sold credit protection.
The 2014 Proposal would restrict the ability of a banking organization to offset the amount of receivables associated with a reverse repurchase agreement with payables due to the same counterparty under a repurchase agreement. The proposal addresses different situations where payments may be owed both ways on repurchase and reverse repurchase agreements between a banking organization and the same counterparty:
- If a banking organization enters into a repurchase agreement that is treated as a sale (an admittedly unusual circumstance in the United States), the banking organization would be required to include the value of the sold securities in total leverage exposure.
- If a banking organization offsets a series of repurchase and reverse repurchase arrangements with the same counterparty (under the terms permitted by GAAP), the organization would be able to use the same offsets for the SLR denominator only if three conditions were met:
- The offsetting transactions have the same explicit final settlement date;
- The right to offset is legally enforceable both in the ordinary course of business and in receivership, insolvency, liquidation, or similar proceeding; or
- The parties have agreed to engage in a net settlement or a functional equivalent thereof. Among other things, cash flows would need to be equivalent.
- In a security-for-security repo-style transaction, a securities lender could exclude a security received as a collateral from total leverage exposure until the lender sells or re-hypothecates the security. If the lender does sell or re-hypothecate the security, the lender would include the cash or the value of the security pledged in total leverage exposure.
- If a banking organization acts as agent in a repo-style transaction and provides a guarantee or indemnity to its client to support the counterparty’s performance, the amount by which the guarantee exceeds the difference between fair value of the security or cash lent and the fair value of the security or cash borrowed would be included in total leverage exposure.
The 2014 Proposal also provides for a counterparty credit risk measure. With respect to any repo-style transaction, a banking organization would be required to include in total leverage exposure the amount by which cash or assets lent to a counterparty exceed the amount of cash or assets received from the counterparty. If there is a master netting agreement, the difference would be determined on a netting basis; otherwise the calculation would be on an individual transaction basis.
Credit Conversion Factors for Off-Balance Sheet Exposures
The 2014 Proposal would eliminate the single, 100 percent credit conversion factor (CCF) that a banking organization subject to the SLR requirement would apply to all off-balance sheet exposures other than unconditionally cancellable commitments (which are converted at 10 percent). The 2014 Proposal would replace the single CCF with the CCFs in the standardized approach in the 2013 Rule that are used to convert off-balance sheet items to the balance sheet for the purpose of determining a banking organization's risk-based capital. The 10 percent CCF would continue to apply to unconditionally cancellable commitments. Note that this requirement, if finalized, would differ from the general risk-based capital rule, which places a 0 percent CCF on unconditionally cancellable commitments.
Central Clearing of Derivative Transactions
The 2014 Proposal would make two clarifications about the treatment of derivative transactions that are centrally cleared. First, the proposal would clarify that the PFE of any derivative, whether or not the transaction has been cleared, be included in total leverage exposure.
Second, the proposal would clarify the treatment of client-cleared transactions. If a bank is acting as agent for a clearing member, the amount of any guarantee of the client’s performance to a central clearing party would be included in total leverage exposure. If the bank serves as an intermediary between a clearing member bank and a CCP, then the amount that the banking organization would be required to pay to the CCP in the event of a clearing member default would be included in total leverage exposure. In addition, if a banking organization were to guarantee the performance of the CCP to the clearing member client, the amount of the guarantee would have to be included in total leverage exposure. If the banking organization makes no guarantee, then no exposure to a CCP would need to be included in total leverage exposure.
The 2013 Rule required that the SLR be calculated as the arithmetic mean of tier 1 capital to total leverage exposure as of the last day of each month in the reporting quarter. The 2014 Proposal would change the calculation of both the numerator and the denominator. The numerator, tier 1 capital, would be determined as of the last day of each reporting quarter. In order to smooth out potential anomalies at the end of a month, total leverage exposure would be the arithmetic mean of such exposure for each day of the quarter.
For the moment, the full impact of the SLR and eSLR requirements is difficult to assess insofar as the requirements do not take full effect until 2018 and insofar as capital planning by advanced approaches bank holding companies is governed largely by the FRB's Comprehensive Capital Analysis and Review (CCAR). Reviewing briefly the FRB's recent report on the 2014 CCAR, the advanced approaches bank holding companies generally meet or are close to meeting the SLR standard. However, a number of companies that will be subject to the eSLR standard may, based on the tier 1 leverage ratios from the third quarter of 2013 that are set forth for the FRB report, may need to manage their leverage between now and 2018.
In any event, the more rigorous treatment of credit derivatives that is part of the 2014 Proposal and the changes to the treatment of repo-style transactions should cause all advanced approaches institutions to revisit the terms of their participation in the markets for these instruments.