This paper aims to explain the relationship between risk-based and leverage ratio (LR) requirements and the motivation for the macroprudential use of LR requirements.
The LR requirement is part of the Basel III reform, and it will be introduced as a Pillar 1 standard to supplement the existing risk-based capital requirements. Since 2015, the disclosure requirement has been in place, and banks have to regularly compute and report their LR. Both the BCBS and the EBA have confirmed that the minimum microprudential LR requirement of 3 per cent is appropriate and should become mandatory. A minimum LR requirement will act as a backstop for risk-weighted capital requirements, by ensuring that a financial institution has a minimum level of equity.
A minimum LR requirement serves as the ultimate backstop against the shortage of equity based on risk-weighted capital requirements. The LR limits the exposure a bank can accumulate in relation to existing capital. It is calculated by dividing the amount of high-quality capital of a financial institution by its total non-risk-weighted exposure. The LR requirement adds an important backstop to the situation when observed risk levels differ significantly from actual unobserved levels, which could materialise quickly. There are merits to using LR requirement add-ons on a macroprudential basis as the internationally agreed-upon LR minimum (3%) might be an insufficiently effective addition to the robust capital framework. A handful of countries, such as the UK, US, Norway and Switzerland, use LR add-ons applied on top of the minimum microprudential LR requirement. However, none of the countries thus far follow a single, common framework when it comes to setting the LR requirement. In addition, when one takes into account recent research on optimal risk-weighted capital levels, the internationally agreed-upon minimum LR requirement of 3 per cent seems to lack effective backstopping power.
The views expressed are those of the author(s) and do not necessarily represent those of the Bank of Lithuania.