Christina Zausner

The regulators are on a roll and in recent weeks they have adopted many final rules that had been sitting in the pipeline for years. Two of them, the Liquidity Coverage Ratio (LCR) and Enhanced Supplementary Leverage Ratio (eSLR), are part of the Basel III framework. Basel III rules are generally considered to be the costliest of reforms for the banking system, and these two finals skewed hard to the conservative.

When talking about the impact of Basel III, it can be useful to visualize a game of Brick Breaker. In this scenario, the regulators are the gamers and they are defending the system by shooting layers of bricks down before the taxpayers are engulfed by a wall of leverage. With these latest LCR and eSLR rules, the authorities are hoping to reduce leverage within the system fairly indiscriminately, as opposed to a risk-based capital regime which is intended to surgically remove higher risk from the system, while maintaining volumes in lower risk instruments.

The regulators pushed the boundaries on both rules. While they fixed certain technical issues within the proposals, they ignored considerable industry concern by setting tougher standards and accelerating the timelines than what were recommended at the international level by the Basel Committee on Banking Supervision. It is clear that in the U.S., the authorities hope to shoot more bricks down rather than fewer – to take more leverage out of the system than less – before the next turn in the economic cycle.

Game Theory

The LCR will force banks to rearrange their balance sheets in favor of a small group of assets – essentially cash, Treasuries, MBS and other liquid instruments. The natural and necessary offset, of course, is that banks will also have to reduce “working assets”, such as loans and guarantees. Like risk-based capital rules, the LCR has the potential to influence strategic decision-making around which business lines get funding. The rule raises the costs on many credit and funding activities, including commercial real estate (CRE) lending and commercial mortgage-backed securities (CMBS).

In contrast, the leverage ratio functions primarily on a top-down basis, and will have less influence at the business line level than the LCR. Under the eSLR, all instruments are treated equally; cash is treated the same as a complex derivative. As such, the eSLR has less to say about what businesses win capital in the allocation process at banks.

But, the eSLR is thought to be more powerful than the LCR in terms of magnitude. It is often debated whether the new leverage regime sets the outer boundary for regulatory capital standards. The regulators, in fact, devised the eSLR as a way to limit the banks’ ability to take liberties with the risk-based capital models. If the regulators were successful in designing the eSLR as intended, new leverage requirements should sit right on top of risk-based capital requirements. While the LCR means some belt-tightening for the banks, it may influence internal resource allocations to and from businesses, the eSLR could have a greater impact on the size of a bank’s total balance sheet.

Liquidity Coverage Ratio Supplementary Leverage Ratio
 Covered Institutions Domestic banks, Savings & Loans with $250 billion in total assets; modified LCR applies to institutions with $50 billion in total assets Advanced approaches banks under Basel III (the largest banks)
 Numerator Highly Qualified Liquid Assets (HQLAs) = cash and cash equivalents mostly Tier I capital
 Denominator Outflows = undrawn commitments and funding obligations (assuming a 30-day stress for the larger institutions, 21-day stress period under the modified approach) Total Assets (including certain off balance sheet exposures)
Ratio Requirements – Holding Companies HQLAs ≥ Outflows 5%
Ratio Requirements – Insured Depositories HQLAs ≥ Outflows 6%
Calculation Frequency Daily Monthly
 Conformance For large institutions, must meet 80% of HQLA requirements by 01/01/15 and 100% by 01/01/17; daily reporting requirements effective on 01/07/15 Must disclose as of 01/01/15 and be in full compliance by 01/01/18

Disciplinary Measures

After 3 days of non-compliance by any amount, institution must file a plan with the regulators At the holding company level, regulators will decide whether to allow an institution to issue dividends and/or bonuses; at the depository level, must enter into “Prompt Corrective Action” regime

Game Changers

Even before these rules were finalized, the regulators were forcing the banks to take action. In the final eSLR rule, the agencies noted that the banks have already closed the leverage requirement gap from 2013 when it stood at $46 billion to where it now stands in 2014 at $15 billion. On the LCR side, the BCBS estimated that globally banks had a shortfall of roughly $456 billion (EUR 353 billion) as of June 30, 2013. In the U.S., banks have been providing preliminary LCR data for years and have already reoriented their balance sheets to a certain degree toward more liquid assets, though it is not clear how far they have gone.

As a result of these supervisory actions and other reforms, we can see major changes at big banks now four years after Dodd-Frank enactment. Looking outside of the CRE and securitization world at another business – interest rates – the combined effects of operational requirements and rising capital costs have resulted in thinning margins. In turn, banks are shedding interest rates activities noticeably.

The Two Playbooks – Monetary and Regulatory Policy

The Senate Banking Committee hearing “Wall Street Reform: Assessing and Enhancing the Financial Regulatory System” held in September gave key Senators the opportunity to grill regulatory heads about their agendas, during which time five agency leaders reiterated that there is more change yet to come. Federal Reserve Board Governor Daniel Tarullo called this period in rulemaking the “beginning of the end”, not the end. Indeed, the list of open items is getting smaller and regulators can now claim that they have partially implemented most of their key reform planks, but several key measures remain outstanding.

At this point, Chair Janet Yellen must be anxious to finish off on the major reforms. In and of itself, outstanding Dodd-Frank obligations are a political liability. This work is also important, because it will lay the groundwork for further removal of monetary policy support. As the head of the central bank, Yellen will want to see that the financial system has absorbed the brunt of structural changes mandated by the Dodd-Frank Act before it begins to challenge the marketplace’s current low-rate mode.

Structural de-leveraging through reforms can have the same effect as raising rates. Both reduce leverage and financial activity, though reforms also address many other issues beyond the reach of monetary policy. With that in mind, it is likely that the Chair Yellen and other members of the Financial Open Market Committee will hope that timing allows for a buffer zone between major structural change and raising rates.