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Special Report – A brief history of banking

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Johan Scheepers discusses the evolution of banking regulation and the new leverage ratio as an additional tool to understanding banks’ and banking groups’ risk

Banking as a business was originally practised in the ancient empires of Babylon, Assyria and Judea. The first “modern” bank was the Bank of Venice, which was founded in 1157.

Two of the first recorded banking crises occurred in England in 1640 and 1672 as a result of excesses by the reigning monarchs.

In 1640 the English monarch at the time, Charles I, appropriated monies from a central depository at the Mint. This is probably the first recorded “unauthorised loan” in history. The loan was repaid but public confidence in the safety of the Mint was compromised.

In 1672 the then monarch, Charles II, borrowed large sums from the bankers of the day and reneged on the principal and the interest. This resulted in the ruin of a number of the lenders.

As a result, the need for a central institution arose to act as an honest custodian of bankers’ or public funds, finally resulting in the incorporation of the Bank of England by Royal Charter in 1694. This was the beginning of financial regulation and the regulation of banks as we know it today.

H A F Barker stated in The principles and practice of banking in South Africa that an examination of the history of financial crises reveals that they have generally been due to one or both of the following circumstances: excessive speculation in trade and industry, or in Stock Exchange securities, and undue expansion of banking credit.

Lessons can and should be learned from financial crashes and that the impact can potentially be minimised by relevant financial regulation. History has taught us are that financial crashes do not occur randomly, but generally follow periods of boom.

The markets may create a crisis by following the general sentiment created by perception or rumour. A classic case in point is the securitisation market in South Africa, which had none of the inherent risks of the securitisation market in the United States, but nevertheless came to a standstill during the 2007 crisis.

Securitisation and re-securitisation contributed substantially to the start of the 2007 banking crisis in the United States.

THE BANKING CRISIS OF 2007Barker’s analysis still holds true today – even if securities need to be expanded to include securitisation products and other more complex derivative products. What this proves is that history will repeat itself with banking crises in spite of the best efforts of governments, regulators, bankers and other stakeholders.

There have been banking crises every couple of years across the world with numerous interventions by central banks and regulators, via regulation, to prevent similar crises from happening again. These regulations were specific to the current crises, but did not deal with the fundamental underlying markets.

The establishment of the Basel Committee in Basel, Switzerland, aimed at addressing some of these shortcomings and providing a more uniform set of regulations for banking industries across the world.

The 2007 crisis resulted in the publishing of Basel III: A global regulatory framework for more resilient banks and banking systems in December 2010 by the Basel Committee on Banking Supervision. These proposed guidelines have been encapsulated into national legislation in a number of jurisdictions across the world in some form or another, including in South Africa.

LEVERAGE RATIO

One of the proposals contained in the Basel III frameworks is the introduction of a leverage ratio. The leverage ratio can be used as a macro- or micro-prudential tool. Both Canada and the United States maintained a leverage ratio pre-2007, but the calculation methodology was different.

In addition, the larger US investment banks were not subject to a leverage limit. In 2008, Switzerland introduced a minimum leverage ratio for Credit Suisse and UBS. An interesting adjustment allowed was that the domestic loan book was not included in the calculation to limit the impact on credit extension in Switzerland.

Basel III states that one of the main reasons the economic and financial crisis, which began in 2007, became so severe was that the banking sectors of many countries had built up excessive on- and off-balance sheet leverage.

The leverage ratio was introduced of which the stated intention was that the leverage ratio was to be a simple, transparent, non-risk-based ratio, calibrated to act as a credible supplementary measure to the risk-based capital requirements.

The proposal of a leverage ratio was intended to achieve the following objectives as per Basel III:

•         Constrain the build-up of leverage in the banking sector, helping to avoid destabilising deleveraging processes which can damage the broader financial system and the economy.

•         Reinforce the risk based requirements with a simple, non-risk-based ’backstop’ measure.

Additional work was undertaken by the Basel Committee regarding the calculation and disclosure of the leverage ratio, which was published in January 2014.  The implementation date for worldwide compliance with the leverage ratio is 1 January 2018.

In terms of Basel III the leverage ratio is defined as the “capital measure” (the numerator) divided by the “exposure measure” (the denominator) and is expressed as a percentage. The capital measure is currently defined as Tier 1 capital, and the minimum ratio is 3 per cent. The inverse of the leverage ratio is the leverage multiple which, based on a leverage ratio of 3 per cent, means 33 times. The higher the leverage ratio is set by the regulators, the less a bank is able to leverage its capital.

Capital measure (the numerator)

Capital is calculated on three different levels for banking regulators, namely Common Equity Tier 1, Tier 1 and Tier 2 capital, resulting in the aggregated total qualifying capital and reserves for a banking entity. The levels are determined based on requirements per the Basel framework. The proposed capital measure for the leverage ratio is currently Tier 1 with a proviso that other capital levels will also be monitored by the Regulators and may be used in future to calculate the leverage ratio. Regulatory deductions are also taken into account when determining the capital measure, for instance investment in insurance entities.

The amount of capital a bank is allowed in the calculation of the leverage ratio will determine the leverage multiple – that is, the amount of exposures a bank may enter into with its clients.

Exposure measure (the denominator)

The original 2010 framework excluded certain assets which are included in the accounting consolidation but not in the regulatory consolidation, for example insurance entities.

The January 2014 framework included a number of additional adjustments which can be made to the exposure amounts and relate to:

•         Securities financing transactions

•         Off-balance sheet items

•         Cash variation margin

•         Central clearing

•         Written credit derivatives

The latest framework allows banks to reduce gross exposures even further for the above categories of exposures. Most of these adjustments relate to trading book exposures and off-balance sheet activities.

DISCLOSURE REQUIREMENTS

As a result of the complexity of the leverage ratio calculation, for comparative purposes, banks will now be required to provide these public disclosures in the annual financial statements:

•         A summary table that provides a comparison of the bank’s total accounting asset amounts and leverage ratio exposures

•         A  disclosure template that provides a breakdown of the leverage ratio regulatory elements

•         Other disclosures, which should include the off balance sheet and derivative adjustments. A proposed template is provided in the framework.

POTENTIAL IMPACT OF A LEVERAGE RATIO

The consequences of a leverage ratio are:

•         Limiting the size of the exposures of a bank. A number of international banks needed to deleverage their balance sheets substantially to meet the proposed leverage ratio or needed to bolster the capital of the banks to support the exposures.

•         Additional reporting to the banking regulators. The leverage ratio is already in the South African banking legislation and the minimum leverage ratio with which banks need to comply is 4 per cent.

•         Disclosure requirements in the annual financial statements. The implementation date for all annual financial statements published after 1 January 2015 will require disclosure.

•         Profitability of banks will be affected as assets being deleveraged will have an impact on profitability. The cost of additional capital will also negatively impact on shareholders’ returns.

•         The type of capital included in the calculation can be material depending on the banking entities’ capital breakdown and there is still the possibility of changes from the Basel Committee.

•         Deleveraging is not a simple process for banks and the assets being deleveraged do not disappear but are still held in non-banking entities within the financial sector. Typically, a number of these types of entities may still be consolidated for accounting purposes, for instance insurance entities within the bigger financial banking group.

•         Non-banking financial entities are not regulated and there is risk of contagion within the financial sector if risky assets are being deleveraged.

•         External auditors will need to understand the leverage ratio calculations as they will form part of the annual financial statements. The effect of non-compliance with the leverage ratio needs to be considered for the auditor’s opinion as it may result in regulatory sanction.

•         Although both Canada and the United States maintained a leverage ratio methodology, the impact of the 2007 crisis was substantially different in the respective countries. The more stringent calculation of the leverage ratio in Canada has been cited as one of the reasons for the strong performance of the Canadian banking sector during the crises by an International Monetary Fund (IMF) country report.

Although the objective of the proposed leverage ratio was to provide a simple ratio, the calculation of the ratio became more and more complex. Consideration of the types of adjustments to the leverage ratio calculation may highlight material differences between banks and banking groups when comparing leverage ratios.

However, an internationally harmonised and calibrated leverage ratio and the disclosure of the calculation adjustments in the annual financial statements may enable regulators, analysts and shareholders to compare banks and banking groups in terms of growth potential and the risk of excessive leverage in an entity or in a system. However, the leverage ratio should not be used in isolation but as part of the overall analysis of a bank or banking group. ❐

Author: Johan Scheepers is a director at KPMG, Johannesburg