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Basel Committee proposes changes to derivatives treatment in leverage ratio

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Basel Committee proposes changes to derivatives treatment in leverage ratio

TheBasel Committee on Banking Supervision has issued a consultative document onthe Basel III leverage ratio framework, proposing changes to the treatment ofderivatives and outlining how the world's largest banks may have to meetadditional requirements.

Thedocument underlines the committee's commitment to the leverage ratio, whichmeasures a bank's capital against its total assets, as a "backstop"measure that complements the risk-based capital framework and helps avoid excessiveleverage. The minimum ratio is 3%.

Thecommittee, which is based in Switzerland, said a higher leverage ratio forglobal systemically important banks, or G-SIBs, may be necessary to maintainthe relative roles of the risk-based ratio and the leverage ratio. It seeks toconsult on whether there should be a limit on Additional Tier 1 capital to meeta higher ratio; whether there should be a uniform additional capitalrequirement for all G-SIBs; and whether the additional requirement should be astructured as a minimum demand or as a buffer. A buffer might be linked todividend restrictions, for example, if it fell below a minimum level.

Revisionsin the document specifically affect the treatment of four areas of bankexposures: The measurement of derivative exposures; regular-way purchases andsales of financial assets; provisions and positions that are relativelyilliquid; and credit conversion factors for off-balance-sheet items.

Incalculating derivative exposures, the committee proposes using the standardizedapproach for measuring counterparty credit risk exposures, admittedly inmodified form. The goal of the changes is to cover a wide range of derivativedeals; address deficiencies of the existing Current Exposure Method; useapproaches already available in the Basel framework; reduce national andcompany discretion; and improve the risk sensitivity of the framework.

Akey issue still under discussion here is the treatment of initial margin postedby clients to banks acting on their behalf as clearing members for centrallycleared derivative transactions. The committee proposes recognizing ascollateral only eligible cash variation margin, while allowing margining to bereflected under shorter time horizon rules. The committee noted that marketparticipants have a number of concerns and that the effect of the marginproposals on their leverage ratio could hit clearing members' ability toprovide clearing services.

Regular-waypurchases and sales of financial assets are affected by accounting differenceswhich themselves influence institutions' leverage ratios under Basel III. Thisis important for market making and market liquidity where offsetting cashreceivables against cash payables plays an important role and is allowed undercertain accounting frameworks. The committee has suggested various options fordealing with the risks contained in these exposures while still not creatingleverage challenges under Basel III.

Onprovisions, the committee proposes to allow those that have decreased Tier 1capital to reduce leverage exposures under Basel III. For off-balance-sheetitems, the credit conversion factors specified under Basel II are to be appliedto the Basel III leverage ratio exposures, subject to a 10% floor. This alignsthe treatment of off-balance-sheet items with the standardized approach tocredit risk.

Thecommittee wants all comments on the proposals to be made by July 6. Theultimate structure of the leverage ratio under Basel III will be stronglyinfluenced by "a comprehensive quantitative impact study."