The Basel III Leverage Ratio has been amended following the Basel Committee on Banking Supervision’s recent publication of its paper, “Basel III Leverage Ratio Framework and Disclosure Requirements”.

The changes to the measure of banks’ exposure under traditional letters of credit for the sale of goods are a welcome revision to their treatment as originally envisaged by the Basel Committee in December 2010.

As a result of the changes, trade finance has successfully been distinguished from other forms of finance. In particular, the credit conversion factor (CCF) for short-term self-liquidating trade letters of credit arising from the movement of goods (e.g., documentary credits collateralised by the underlying shipment) is 20 percent and no longer 100 percent. This CCF will be applied to both issuing and confirming banks. The reduction of this CCF demonstrates recognition by the Basel Committee of the generally low-risk nature of these types of payment instruments for banks involved in trade finance. The differentiation of documentary credits from other off-balance sheet items under the Leverage Ratio makes sense. Such trade finance instruments are usually backed by a flow of physical goods and are usually short-term exposures for banks. Coupled with their self-liquidating nature, the reduced CCF better reflects that documentary credits in trade transactions do not generally pose high leverage risks.

This relaxation in treatment of documentary credits has to be a positive change for traders and banks. Traders can continue to trade using documentary credits without incurring greater costs for such payment instruments. Banks in this business can continue to engage in these off-balance sheet transactions.

What is the Leverage Ratio?

In addition to further refining the capital adequacy regulations under Basel II and making other adjustments, Basel III introduced some new requirements. One of these was the Basel III Leverage Ratio which acts as a control on the amount of banks’ indebtedness. In the Basel Committee’s recent paper, it stated that this “non-risk based ’backstop‘ measure” is “intended to restrict the build-up of leverage in the banking sector to avoid destabilising deleveraging processes that can damage the broader financial system and the economy”.

The Leverage Ratio is calculated by taking a bank’s “capital measure” and dividing this by its “exposure measure”. It is measured as a percentage and the minimum requirement is 3 percent from 1 January 2013 to
1 January 2017.

The “capital measure” is the Tier 1 capital as that definition has been reinforced under Basel III.

The “exposure measure” consists of the total of: (i) on-balance sheet exposures; (ii) derivative exposures; (iii) securities financing transaction exposures; and (iv) off-balance sheet items.

Off-balance sheet items are as defined under Basel II and include short-term self-liquidating trade letters of credit arising from the movement of goods now with a CCF of 20 percent. Before this change, a CCF of 100 percent applied to all off-balance sheet items. The recent changes, however, under the Basel Committee’s paper have brought the levels of CCFs back to the same as those applicable under the standardised basis of assessment for credit risk under Basel II.*

What is a Credit Conversion Factor?

A CCF is a percentage that is applied to the value of the relevant instrument or transaction which results in a “credit exposure equivalent”. Such percentage reflects how likely the instrument may become an exposure on the bank’s balance sheet. The CCF effectively therefore gives a value for the amount that the bank is exposed to on its balance sheet in respect of such instrument or transaction.

Implementation

The Leverage Ratio will be implemented on 1 January 2018. Prior to that banks are required to report their Leverage Ratio and underlying calculation during a parallel run period between 1 January 2013 and 1 January 2017, and the Basel Committee will monitor the same. Banks will also be required to publicly disclose their Leverage Ratio on a consolidated basis from 1 January 2015. The Basel Committee’s paper states that the definition and calibration of the Basel III Leverage Ratio may be finally adjusted by 2017 further to the results of the parallel period.

Following the issue of the Basel Committee’s paper, “Basel III Leverage Ratio Framework and Disclosure Requirements”, the change to the exposure measure of the Leverage Ratio is a good result for banks in the business of issuing or confirming short-term documentary letters of credit for its customers. Banks and, indirectly, customers should no longer face the risk of increased costs due to excessive capital costs with respect to these payment instruments. In addition, banks should be able to continue supporting global trade by remaining active within this classic area of trade finance.

* The CCF referred to in this alert is the CCF to be used in calculating the exposure measure for the purpose of determining the Leverage Ratio under Basel III. This is different to the CCFs applicable under the standardised approach under Basel II for assessing credit risk and the amounts of regulatory capital required. When calculating exposure values to determine its regulatory capital, a firm applies risk weightings to its exposures by applying CCFs in respect of certain risk categories.

Client Alert 2014-077