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Basel IV Framework

Revisions to the Leverage Ratio

November 2018

Briefing Paper

By Azad Ali, Chris Hobson and Steven Burrows

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The leverage ratio has been a critical component in the tightening of bank capital standards set out in the "Basel III" framework issued in the aftermath of the financial crisis. The Basel Committee issued revisions to the leverage ratio standard in December 2017 as part of the "Basel IV" package of capital reforms. Additional changes have recently been proposed responding to ongoing concerns around the adverse impact on bank incentives to provide derivatives client clearing services. For many banks, compared to risk capital standards, the leverage ratio has acted as a significant balance sheet and profitability constraint and as a driver of change for key business lines. This will continue to be the case notwithstanding a strengthening of the risk capital framework in Basel IV. This briefing summarises the Basel IV Leverage Ratio and highlights key impacts for banks. Certain points of comparison with the EU capital framework, which is currently being revised to implement various enhancements and additions to the Basel III framework, are also included.

Introduction In December 2017, the Basel Committee on Banking Supervision (the "BCBS") published extensive revisions to several capital standards. This package of revisions to the capital framework (commonly known as "Basel IV") includes new standards on the credit risk capital regime through changes made to both the Standardised Approach and the Internal Ratings Based ("IRB") approach, a new capital floor for IRB approach banks and a new standardised methodology for determining minimum capital requirements in respect of operational risk. In addition, there is a revised formulation of the leverage ratio, which is the subject of this briefing (the "Basel IV Leverage Ratio"). Further changes to elements of the Basel IV Leverage Ratio have recently been proposed for consultation.1 We highlight the key elements of the Basel IV Leverage Ratio and describe its impact on both banks and those broker-dealers that are subject to leverage ratio constraints. The Basel IV Leverage Ratio has a 1 January 2022 timeline for implementation. At present, several key BCBS member jurisdictions have not yet fully implemented the existing Basel III standard.2 In the EU, the European Commission has submitted a proposal to amend the Capital Requirements Regulation ("CRR")3 in order to incorporate changes and additions to the Basel III standards since those were finalised in 2011. Included within this package are further refinements to the existing leverage ratio, which follows the standard as finalised by the BCBS in 2014.4 As such, this legislative process does not currently implement the Basel IV Leverage Ratio. That said, certain changes introduced in the Basel IV Leverage Ratio might be incorporated as part of the EU legislative process revising the CRR. For instance, the European Commission has indicated that the leverage ratio buffer for G-SIBs may be incorporated in the revised CRR.

Various concerns were raised by the banking industry in response to draft proposals for the Basel IV Leverage Ratio issued by the BCBS in April 2016 (the "Proposed Revisions").5 Issues included the treatment of initial margin collateral provided by cleared derivative clients, limitations on exposure-reducing effects of cash variation margin ("CVM") posted in relation to derivatives trades in currencies other than the settlement currency, and the introduction of risk adjustment into the calculation of derivatives exposures. These concerns have not been fully met in the Basel IV Leverage Ratio (although the treatment of initial and variation margin posted by clients of clearing members in connection with cleared derivatives is now being revisited). In some cases the final standards exacerbate some of these concerns. In the case of the new leverage ratio buffer requirement for global systemically important banks ("G-SIBs"), this was merely presented for consideration and not fully articulated in the Proposed Revisions.

The core leverage ratio The leverage ratio is a measure of capital adequacy intended to complement the risk-based capital requirements of firms subject to the Basel standards. Firms subject to the Basel IV Leverage Ratio must maintain a 3% leverage ratio minimum requirement at all times. This ratio is determined by dividing the 'Capital Measure' by the 'Exposure Measure'. The Capital Measure is the Tier 1 capital of the institution, which is the sum of Common Equity Tier 1 and Additional Tier 1 instruments issued by the institution. The Exposure Measure is determined in accordance with paragraphs 20 to 59 of the Basel IV Leverage Ratio. Essentially, the Exposure Measure is the sum of the non-risk based (i.e. gross accounting values) of the institution's exposures. Institutions must not take any credit risk mitigation, including physical or financial collateral, into account.

The calibration of the Exposure Measure is controversial in a number of respects and may arguably lead to artificially increased exposure values relative to actual economic exposures. Key features of the Exposure Measure calculation are explored more fully below.

Consolidation The Basel IV Leverage Ratio allows the same scope of regulatory consolidation as the risk-based capital framework. Generally speaking, the regulatory consolidation under the risk-based

1. BCBS Consultation Leverage ratio treatment of client cleared derivatives, October 2018 available here.

2. Fourteenth progress report on adoption of the Basel regulatory framework, April 2018 available here.

3. Regulation (EU) No. 575/2013.

4. Basel III leverage ratio framework and disclosure requirements, January 2014, available here.

5. The Proposed Revisions were addressed in our briefing of 12 April 2016, available here.

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capital framework requires the consolidation of entities in the firm's group that carry out banking, financial, insurance or certain commercial activities. Where an affiliate that carries out such activities is outside of the regulatory consolidation of the firm, only the investment in the capital of that affiliate (i.e. the carrying value of the investment as opposed to the underlying assets of the investee entity) is included in the Exposure Measure. In addition, investments in the capital of such entities that are deducted from Tier 1 capital according to the risk-based capital framework may also be deducted from the Exposure Measure. Derivative exposures The treatment of derivative exposures in both the cleared and uncleared contexts has been the subject of substantial industry commentary. Key elements of the Exposure Measure, as contributed to by derivatives positions, are explained below. Under the Basel IV Leverage Ratio, exposure values of derivative transactions must be determined using the standardised approach to counterparty credit risk ("SA-CCR")6 but with some modifications ("Modified SA-CCR"). The SA-CCR has replaced the Current Exposure Method ("CEM") and the Standardised Method ("SM") for measuring derivatives counterparty credit exposures. Both of these methods fail to accurately reflect the true exposure value of derivative contracts. The CEM does not differentiate between margined and unmargined transactions and the recognition of netting benefits is seen to be overly simplified. The SM had similar shortcomings, and the inadequate definition of 'hedging set' used in the SM framework has led to inconsistent application by banks as well as operational complexity. The SA-CCR is designed to be a more risk-sensitive and improved basis for measuring counterparty risk than the either the CEM or SM. In addition to its use as an input in the Exposure Measure, the SA-CCR is used as the basis for measuring derivatives exposures in other areas of the capital framework, such as the credit risk capital framework and restrictions on large exposures. The SA-CCR is being implemented in the EU as part of the revisions to CRR albeit with some deviations from the Basel standards. Modified SA-CCR – Key Features: Derivative exposures measured under the SA-CCR consist of two components: the replacement cost ("RC") of a derivative transaction or netting set and the potential future exposure ("PFE") attributable to the derivative transaction or netting set. The RC is intended to capture the loss that would occur if a counterparty were to default, assuming that the close-out and replacement of transactions occur instantaneously. Accordingly, the RC is the market value of the derivative transaction or transactions in the netting set less eligible CVM (but ignoring any initial margin or excess collateral). Eligible CVM is recognised as an offsetting input into the Exposure

Measure (see further below). The PFE is an add-on to the RC which captures the potential change in value of trades during the margin period of risk (i.e. the time period between the last exchange of collateral before default and the replacement of the relevant trades in the market). The PFE is a function of the value of derivatives in the netting set (adjusted for remaining maturity)7 and the underlying asset class. PFE Multiplier: In the risk capital framework, a multiplier for the netting set has to be determined. The multiplier decreases as excess collateral amounts increase. A lower multiplier will decrease total PFE, so overall exposure in relation to the netting set would be lower in cases where excess collateral is held. However, when calculating PFE for the purposes of the leverage ratio, the multiplier is fixed at 1. Using a multiplier of 1 ensures that the level of collateral held to cover the derivatives exposure is treated as being equal to or less than the net market value of the position, despite any excess collateral actually held by the firm in respect of the position.8 This is in line with the BCBS's policy aim of ignoring any credit risk mitigation (which includes any excess collateral) when determining leverage exposures. However, calibrating the PFE in this way may result in an artificial overstatement of leverage in respect of derivative transactions given that such transactions are subject to margin requirements for uncleared derivatives that may result in excess collateralisation. By not taking excess collateral into account when determining the PFE, counterparties are required to hold capital in respect of a position that does not give rise to an economic exposure, or which would otherwise be materially reduced through the application of the normal SA-CCR framework. Scalar Alpha Factor: In the risk capital framework, the exposure value of a derivative transaction calculated under the SA-CCR is adjusted by a fixed multiplication factor of 1.4. This alpha multiplier is carried over from the alpha value set in respect of the internal model method for determining counterparty credit risk weightings. This multiplier is intended to address model risk inherent in an internal model method as well as any correlation risk linked to related exposures across counterparties. As such, the alpha factor adjusts the value of derivative exposures to take these risk factors into account. This multiplication factor also applies to the Modified SA-CCR in the leverage ratio context. However, this is inconsistent with the premise of the leverage ratio framework, which is to determine leverage exposure in accordance with gross accounting values that have not been adjusted for risk. Replacement Cost – Recognition of Cash Variation Margin: As noted above, the CVM received may be used to reduce the RC component of the Exposure Measure, and any posted CVM may be deducted from the Exposure Measure, provided in each case the CVM meets the following conditions:9

6. The SA-CCR is set out in the BCB’s Standardised approach for measuring counterparty credit risk exposures, March 2014 (Revised April 2014). 7. The SA-CCR allows firms to modify their PFE in accordance with a maturity factor determined by reference to the maturity factor appropriate to the underlying transactions in the netting set. Firms may

rely on clearing processes that reduce the maturity factor. In particular, CCPs may offer 'settlement-to-market', which enables the transfer of daily variation margin to effectively reset the remaining maturity

of each derivative contract to the next settlement date (i.e. the next day), regardless of the tenor of the underlying contracts. As such, derivatives that are settled to market attract the lowest maturity factor

and therefore a lower PFE.

8. Under the normal SA-CCR framework, excess collateral may be recognised to reduce the multiplier used to determine the PFE by up to 95%.

9. Paragraph 39, Basel IV Leverage Ratio.

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i. CVM received in respect of uncleared derivatives must not be segregated (there must be no restrictions on the ability of the recipient counterparty to use the cash received); ii. CVM must be calculated and exchanged on at least a daily basis based on a mark-to-market valuation of derivative positions; iii. the CVM received must be in a currency specified in the derivative contract, the master agreement, the credit support annex or as defined in any netting agreement with a CCP; iv. CVM exchanged must be sufficient to extinguish the mark- to-market exposure of the derivative, subject to the threshold and minimum transfer amounts applicable to the counterparty; and v. derivative transactions and CVM must be covered by a single, legally enforceable master agreement between the counterparties. Condition (iii) above recognises that trades documented under a netting agreement may be subject to differing settlement currencies. In such a situation, net amounts, under margin calls for example, could be expressed in a single currency as specified in a CSA. Individual trades could of course be in a currency different from the termination currency specified in the netting agreement or from the currency of the collateral specified in the CSA. The recognition of currencies other than the currency of the derivative transaction for the purposes of CVM eligibility is a welcome improvement on the Proposed Revisions. Further, the Basel IV Leverage Ratio does not require counterparties to apply an FX haircut where the currency of the CVM does not match the termination currency of the netting set. As respondents to the Proposed Revisions highlighted, applying an FX haircut at the level of the netting set would not be appropriate given that current market practice for both cleared and uncleared derivatives is to specify a single termination currency for each currency silo to be exchanged on a gross basis on default.

Treatment of Margin: The Modified SA-CCR does not take initial margin into account when calculating the RC component. In the SA-CCR used in the risk capital framework, RC is defined as "the greatest exposure that would not trigger a call for variation margin".10 As such, RC is calculated by reference to the value of the netting set as offset by variation margin received. RC is then reduced further by the net independent collateral amount

("NICA"). NICA is the amount of collateral that a firm may use to offset its exposure on the default of its counterparty, i.e. initial margin or an independent amount. NICA does not take into account any initial margin posted by the firm to the extent it is posted on a segregated, bankruptcy remote basis as the firm would not in these circumstances be exposed to its counterparty for the return of such posted collateral on the default of the counterparty. NICA is not taken into account at all when determining RC under the Modified SA-CCR. As such, the RC value for the purposes of the Basel IV Leverage Ratio will generally be higher than that calculated under the risk capital framework. Given the impact of this in relation to client cleared derivatives in particular, the BCBS has initiated a consultation on the recognition of NICA as part of the Modified SA-CCR (see below).

Treatment of clearing services When clearing derivative transactions on behalf of clients, firms acting as clearing members may be required to reimburse clients for any losses suffered by the client should the central counterparty ("CCP") default. Where this arrangement is in place, firms must include their trade exposures to CCPs in the Exposure Measure, calculated in accordance with the Modified SA-CCR framework. If the clearing arrangement with the client does not require the firm to reimburse the client for any losses arising from the default of the CCP (as is typically the case in client or indirect clearing arrangements), the firm is not required to include trade exposures to CCPs in its Exposure Measure. Banks may act as 'higher level clients' within a multi-client indirect clearing structure. In a simple indirect clearing structure, a bank might provide clearing services to end clients by submitting end client trades to a clearing member, rather than acting as the clearing member itself. In these circumstances, the bank would not be required to recognise trade exposures to the clearing member in the Exposure Measure, provided that: i. the transactions are identified by the CCP as higher level client transactions and collateral to support them is held by the CCP/clearing member, as applicable; ii. the bank acting as higher level client has conducted a legal review which is sufficient to enable it to conclude that, in the event of legal challenge, a court would find that the indirect clearing arrangements would be legal, valid, binding and enforceable; iii. if the clearing member defaults, offsetting transactions with the defaulted clearing member will be likely to continue to be indirectly cleared through the CCP by virtue of, for instance, the default procedures of the CCP; and iv. the bank is not obliged to reimburse the end client for any losses suffered in the event of default of either the CCP or the clearing member. Under Article 429c(4) of the revised CRR proposal, any collateral

10 Paragraph 140, Standardised approach for measuring counterparty credit risk exposures.

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received in respect of derivative contracts cleared through QCCPs (i.e. CCPs authorised or recognised under EMIR)11 may be excluded from the Exposure Measure. The conditions set out above do not have to be met for such trade exposures to be discounted for the purposes of the revised CRR. In this respect, the EU position deviates from the Basel IV Leverage Ratio in setting out a more industry-friendly response to the concern that higher capital charges would dis-incentivise client clearing of derivatives. The BCBS has recently issued a consultation paper on whether to permit banks to exclude trade exposures to CCPs from the Exposure Measure where such exposures arise in the context of client clearing. This responds to concerns that inclusion of trade exposures to CCPs in the context of client clearing would dis-incentivise client clearing. The consultation paper proposes two options for dealing with trade exposures to CCPs in the context of client cleared derivatives. Option 1 amends the Modified SA-CCR to allow banks to include cash and non-cash initial margin received as part of a client clearing arrangement to offset PFE for client cleared derivatives only. Option 1 therefore results in partial recognition of collateral as reducing the Exposure Measure for client cleared derivatives. Option 2 aligns the Modified SA-CCR with the SA-CCR formula used in the risk-based capital framework. This would result in the full recognition of both cash and non-cash initial margin and variation margin, thereby reducing the exposure value to that under the unmodified SA-CCR where both initial and variation margin may offset the RC and PFE. The consultation paper also leaves open the possibility that the Modified SA-CCR as set out above will remain in place with respect to client cleared derivatives.

Credit derivatives In order to recognise the notional credit exposure arising from the creditworthiness of the reference entity in credit derivatives written by the firm, the protection provider is required to include the notional amount of the underlying as well as any counterparty credit exposure in the Exposure Measure. This exposure value may be reduced by any negative fair value that has already been recognised in Tier 1 capital and by the notional amount under any credit derivative purchased by the protection provider on the same reference entity. In relation to the latter offset, the Basel IV Leverage Ratio introduces new rules to address wrong-way risk where there is a correlation between the reference entity and the

counterparty from whom protection is purchased. Other changes notably include the option of a partial reduction of the PFE in respect of written credit derivatives that are not offset by purchased credit derivatives on the same reference entity, if the effective notional of the underlying is already included in the Exposure Measure.

Treatment of securities financing transactions (“SFTs”) Both the gross value of SFT assets (ignoring any collateral) and a measure of counterparty credit risk must be included in the exposure value of SFTs for the purposes of the Exposure Measure. The value of securities received under an SFT where the bank has recognised the securities as an asset on its balance sheet may be excluded from the Exposure Measure. Generally speaking, however, securities loaned or securities collateral received remain on the balance sheet of the lender and borrower respectively. Further, where there is more than one SFT with the same counterparty, the net amount of cash payable and receivable (as opposed to gross exposure) across the SFTs can be reflected in the Exposure Measure provided certain conditions are met. These include the need for the SFTs to have the same final settlement date. Cash netting in open repos where there is no end date is not recognised for the purposes of reducing the Exposure Measure. This difference in treatment between repos with a settlement date and open repos is difficult to justify given that both types of repo are functionally equivalent from the perspective of market participants in certain jurisdictions, particularly in the context of overnight repos. The BCBS received submissions from industry on this issue following the Proposed Revisions, but chose ultimately not to amend the rule under the Basel IV Leverage Ratio.

Additional leverage ratio buffer for global systemically-important banks (G-SIBs) Banks identified as G-SIBs according to the Financial Stability Board's list of G-SIBs (available here) must meet a leverage ratio buffer requirement in addition to the core leverage ratio. G-SIBs must meet the leverage ratio buffer with Tier 1 capital. The leverage ratio buffer is calibrated at 50% of a G-SIB's risk buffer requirement. As such, a G-SIB subject to a 2% risk buffer requirement would be subject to a 1% leverage ratio buffer. The leverage ratio buffer applies in addition to the capital conservation buffer, the G-SIB risk buffer and the countercyclical capital buffer (if applicable). Tier 1 capital used to satisfy these buffer requirements cannot be double-counted towards the satisfaction of other capital requirements applicable to G-SIBs, including total loss-absorbing capacity ("TLAC"). As such, G-SIBs may be required to bolster Tier 1 capital to satisfy the buffer requirements in addition to TLAC requirements. According to the Basel III Quantitative Impact Study of December 2017,12 the introduction of the leverage ratio buffer would result in a capital shortfall of €12.4 billion, spread across four banks who were

11. European Markets Infrastructure Regulation 2012/648.

12. Basel III Monitoring Report - Results of the cumulative quantitative impact study, December 2017, available here.

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deemed to be impacted. 13 G-SIBs that breach the leverage ratio buffer requirement will be subject to capital conservation measures, including restrictions on distributions and a requirement to prepare a capital conservation plan. Any breach of the leverage ratio buffer must also be reported to the G-SIB's regulator. A number of jurisdictions have already implemented leverage ratio standards that require G-SIBs to satisfy stricter leverage ratios. In the UK, the Financial Policy Committee ("FPC") issued a Policy Statement calibrating supplementary leverage ratio buffer requirements (both a fixed additional leverage ratio buffer and a countercyclical leverage ratio buffer) for systemically important banks in the UK, which was subsequently adopted by the PRA (the "UK Leverage Ratio Buffer").14 Under the UK Leverage Ratio Buffer, systemically important banks have to meet an additional leverage ratio buffer with mainly CET1 instruments (although 25% of the requirement can be met with AT1 instruments), calibrated at 35% of their G-SIB risk buffer. Further, the PRA may impose an additional countercyclical leverage ratio buffer set at 35% of the firm's risk-weighted countercyclical buffer rate. The FPC has indicated that it may review whether changes to the UK Leverage Ratio Buffer are required due to changes in the international regulatory framework, particularly as a result of changes made in the EU regime following revisions being made to the CRR.

Traditional securitisations An originating bank in a traditional securitisation may exclude securitised exposures from its Exposure Measure if the securitisation meets the requirements in respect of risk transfer set out in the BCBS's Revisions to the Securitisation Framework.15 These requirements include an obligation on the originating bank to transfer significant credit risk associated with the underlying securitised exposures to third parties as well as to transfer all effective or indirect control over the securitised exposures. The originating bank must include any retained securitisation exposures maintained in accordance with local risk retention requirements in its Exposure Measure. The originating bank must also include all exposures which are the subject of synthetic securitisations in the Exposure Measure.16

Treatment of provisions General provisions or general loan loss reserves (as defined in paragraph 60 of the Basel III framework) which have reduced Tier 1 capital may be deducted from the Exposure Measure. As such, both general and specific provisions that have been accounted for in Tier 1 capital may reduce the Exposure Measure. Similarly, exposures from off-balance sheet items, after applying the relevant credit conversion factor ("CCF"), are also now to be reduced by provisions, both general and specific. A further adjustment to exposure values applies in respect of prudent valuation adjustments for less liquid on-balance sheet positions.

Sales and purchases of financial assets For sales in financial assets that give rise to settlement risk between the trade date and settlement date, purchasers are exposed to the risk in the change in value of purchased assets between the trade and settlement dates as well as to any asset that is the source of payment. Sellers are exposed to the risk of non-payment of the purchase price. Accounting frameworks are not harmonised as to trade date or settlement date accounting approaches which has led to differences between banks in the way settlement risks are reflected on their balance sheets and as a result their associated capital requirements. The Basel IV Leverage Ratio acknowledges the difference between the trade date and settlement date accounting approaches. Thus, firms using trade date accounting must reverse out of any offsetting between cash receivables for unsettled trades and cash payables for unsettled purchases that may be recognised under the applicable accounting framework. Such banks may offset between those cash receivables and cash payables if (i) the financial assets bought and sold that are associated with the cash payables and receivables are fair valued and are included in the bank's regulatory trading book; and (ii)

the transactions are settled on a delivery-versus-payment basis. Firms using settlement date accounting must treat unsettled financial asset purchases as off-balance sheet items subject to a CCF of 100%.

Off-balance sheet items Off-balance sheet ("OBS") items are converted under the Standardised Approach for credit risk into credit exposure equivalents through the use of CCFs. The CCFs must be applied to the notional amount of OBS items.17 As an example, direct credit substitutes such as guarantees will receive a CCF of 100%, whilst a 50% CCF will apply to note issuance facilities. The CCFs used for the purposes of the Basel IV Leverage Ratio are more granular than those used in Basel III. Under Basel III, most OBS items attracted a 100% CCF; only commitments unconditionally cancellable by the bank at any time received a different CCF of 10%. Under the Basel IV Leverage Ratio, certain OBS items such as note issuance facilities and transaction-related contingent items (such as performance bonds) attract a 50% CCF.

13. Paragraph 5.2, Basel III Quantitative Impact Study.

14. The Financial Policy Committee's powers over leverage ratio tools, July 2015, available here. The PRA implemented the FPC recommendations as part of PS 27/15, available here.

15. The BCBS's Revisions to the securitisation framework are available here.

16. In the EU, financial institutions are prohibited from holding exposures in respect of securitisation positions unless the originator has disclosed that it will retain a material net economic interest in

the securitisation of at least 5% (Although in certain cases the financial institution may be required to retain more than 5% - Article 405 CRR; Article 6 Regulation 2017/2402 (the "Securitisation

Regulation")).

17. The CCFs are set out in the Annex of the Basel IV Leverage Ratio.

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Cash pooling Cash pooling products are offered by banks to enable the combination of the credit and debit balances of several individual participating customer accounts into a single account balance to facilitate cash management. The Basel IV Leverage Ratio allows banks to count the single account balance towards the Exposure Measure, rather than the individual participating accounts, provided that the cash pooling arrangement entails a transfer on at least a daily basis of the balances of the individual participating accounts. Where the balances of such accounts are consolidated into a single account less frequently, the bank may treat the single account as the basis for the Exposure Measure only where certain conditions are met. These conditions include that the bank must have a legally enforceable right to transfer the balances of participating accounts and must be able to exercise this right at any time.

Central bank reserves The Basel IV Leverage Ratio allows jurisdictions to temporarily exempt central bank reserves from the Exposure Measure in exceptional macroeconomic circumstances. However, where a jurisdiction applies this discretion it must increase the calibration of the minimum leverage ratio requirement to offset the impact of exempting central bank reserves. Firms that exempt central bank reserves from the Exposure Measure on the basis of the national discretion to allow for such exemption must disclose the impact of such temporary exemption on their capital position. Such firms must also continue to publish their leverage ratios calculated without the application of the exemption. Under the proposed revisions to the CRR, EU member states are not granted the discretion to exempt central bank reserves from the Exposure Measure. This might be reconsidered in the ongoing legislative procedure applicable to the CRR.

Supervisory vigilance against certain leverage-reducing transactions

The BCBS has indicated that national supervisors should be vigilant to any transactions or arrangements having the effect of reducing the Exposure Measure and which may not adequately capture sources of banks' leverage, including through the use of SFTs. Illustrative examples given include where banks, who normally transact as principal, adopt an agency model in respect of derivatives and SFTs in order to avoid the leverage ratio impact

arising from such trades. National banking supervisors are urged to apply careful scrutiny to such transactions and, where necessary, impose supervisory measures such as an additional Pillar 2 capital surcharge and additional reporting requirements.

Calculation frequency, reporting and "window-dressing" Under the Basel III standard, firms must calculate the leverage ratio and report the calculation in accordance with the disclosure requirements set out in Basel III as at their reporting reference date for financial reporting. Most firms will therefore calculate and disclose their leverage ratio on a quarterly basis. This requirement is reflected in Article 429(2) CRR, so EU firms subject to CRR are only required to satisfy the leverage ratio on a quarter-end basis. The Basel IV Leverage Ratio does not change the quarterly determination of the leverage ratio, although the BCBS has published a further proposal to change the scope of quantitative information to be disclosed in the report in respect of the leverage ratio. Outside of the EU, firms may be subject to more frequent calculations by their national supervisors. For instance, in the U.S., firms are required to use daily averaging to determine the leverage ratio. These jurisdictional discrepancies have led to arbitrage concerns. In particular, there is concern that firms subject to less frequent calculation may engage in 'window-dressing' transactions that have the effect of reducing the Exposure Measure around their reporting reference dates with reversing transactions effected immediately after the reporting reference date. Supervisors in jurisdictions that only require quarterly calculation may therefore be more likely to scrutinise any such actions by banks. The BCBS has indicated that such action by regulators will be required in the future. In a statement published on 18 October 2018, the BCBS stated that "[w]indow-dressing by banks is unacceptable" and that "[b]anks should…desist from undertaking transactions with the sole purpose of reporting and disclosing higher leverage ratios at reporting days only."18 Accordingly, it is likely that the potential for window-dressing around the reporting date will be reduced and that banks will be required to ensure compliance on an ongoing basis with the leverage ratio requirement, rather than shoring up balance sheets on a quarterly basis at reporting reference dates.

18. BCBS Statement on leverage ratio window-dressing behaviour, 18 October 2018.

This publication is not a substitute for detailed advice on specific transactions and should not be taken as providing legal advice on any of the topics discussed. © Copyright Fieldfisher LLP 2018. All rights reserved. Fieldfisher LLP is a limited liability partnership registered in England and Wales with registered number OC318472, which is regulated by the Solicitors Regulation Authority. A list of members and their professional qualifications is available for inspection at its registered office, Riverbank House, 2 Swan Lane, London, EC4R 3TT. We use the word “partner” to refer to a member of Fieldfisher LLP, or an employee or consultant with equivalent standing and qualifications.

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Briefing Paper

Contacts

Christopher Hobson Solicitor - London Financial Services Regulation E: christopher.hobson@fieldfisher.com T: +44 (0)20 7861 4894

Azad Ali Partner - London Financial Services Regulation E: azad.ali@fieldfisher.com T: +44 (0)20 7861 4861

Thilo Danz Partner - Germany Financial Markets & Products E: Thilo.Danz@fieldfisher.com T: +49 6920 434 2152

Rüdiger Litten Partner - Germany Financial Markets & Products E: Ruediger.Litten@fieldfisher.com T: +49 6920 434 2151

Ingrid Dubourdieu Partner - Luxembourg Financial Markets & Products E: Ingrid.Dubourdieu@fieldfisher.com T: +352 621 359 076

Arnaud Grünthaler Partner - France Financial Markets & Products E: Arnaud.Grunthaler@fieldfisher.com T: +33 (0)1 70 37 81 77

Steven Burrows Associate - London Financial Services Regulation E: steven.burrows@fieldfisher.com T: +44 (0)20 7861 4548

Thorsten Voss Partner - Germany Financial Markets & Products E: Thorsten.Voss@fieldfisher.com T: +49 69 204 342 155

Carmelo Raimondo Partner - Italy Financial Markets & Products E: Carmelo.Raimondo@fieldfisher.com T: +39 02 806 731