Game On: Basel III Rules Poised to Extract Leverage from the System he 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 CRE Finance World Autumn 2014 22 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 decisionmaking 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. T Christina Zausner Vice President, Industry and Policy Analysis CREFC 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.
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