Ingves: Banking on Leverage

Date 27/02/2014

Bank operations are largely funded by debt, but supervision is needed to ensure that banks do not fund their operations with too great a proportion of debt and too little equity. The definition for the calculation of the leverage ratio that was recently agreed upon by the Basel Committee measures precisely this relation, i.e. a bank's leverage, and is therefore an important component of the Basel III regime. This was pointed out by the Governor of the Riksbank, Stefan Ingves, in his role as Chairman of the Basel Committee on Banking Supervision (BCBS) when speaking at a conference organised by the BCBS, the Financial Stability Institute and the Executives' Meeting of the East Asia-Pacific Central Banks' Working Group on Banking Supervision in Auckland, New Zealand, on 27 February 2014.

 

Governor Ingves briefly explained the reasoning behind the leverage ratio. In simple terms, a bank can choose to fund its assets by using either debt (for example bonds or deposits from the public) or equity (capital such as shareholders' equity). As debt is often a less expensive form of funding than equity it is also attractive to the banks. However, too much debt makes a bank vulnerable in times of stress as its income may fall or the bank may need to take a loss and could therefore find it difficult to repay its debt. In such cases, there must also be equity that the bank can use to cover this shortfall. This is where the leverage ratio comes in. The leverage ratio measures to what extent a bank has funded its assets with equity (rather than with debt). Governor Ingves said that the leverage ratio is intended to provide an extra safety net but that it is not intended to be used in isolation, separately from the other Basel ratios for capital and liquidity. These should instead be seen as a package in which the ratios complement each other.

 

Governor Ingves also pointed out that the recently agreed definition of the leverage ratio relates to how it should be calculated and publicly reported. According to the Basel standard, internationally active banks should begin publishing their leverage ratios in 2015 and the intention is that the leverage ratio will become a binding minimum requirement in January 2018.

 

Read the whole speech via the link.