European banks should have at least 3 cents of capital for every euro of assets they hold, the European Banking Authority recommended.
The measure would help reduce the risk of lenders taking on too much debt, while its impact on their ability to finance the economy would be “relatively moderate” at that level, the EBA said in a report Wednesday. While the world’s biggest, most systemically important banks may merit a tougher requirement, overall the result will be a more stable financial system, it said.
Regulators agreed to set a binding leverage ratio to ensure that banks would be unable to reach the levels of indebtedness that in 2008 helped plunge the global economy into the deepest crisis since the Great Depression. The measure, which treats a euro invested in a high-yield bond as bearing the same risk of loss as a euro invested in a German government bond, is designed to complement and backstop the risk-weighted approach which banks typically use.
“The overarching aim of the leverage ratio regulation is to limit the build-up of leverage to the degree that financial institutions do not end up with excessive leverage,” the EBA said in the report. “The leverage ratio and the risk-based capital requirements should function in a complementary manner, with the leverage ratio defining a minimum capital to total exposure requirement and the risk-based capital ratios limiting risk-taking.”
Many European banks are already preparing to meet minimum leverage ratio requirements. Deutsche Bank AG said last year it aimed to have a 4.5 percent ratio by 2018. U.S. regulators have set a 5 percent minimum ratio for that nation’s largest banks, applying slightly different criteria.
The EBA recommended applying the measure from January 2018 and said it should be part of banks’ mandatory, or Pillar 1, requirements. The EBA report will now go to the European Commission, the bloc’s executive arm, which will propose legislation and will report to the European Parliament and Council on the impact and effectiveness of the ratio by year-end.
In stress tests published last week based on lenders’ balance sheets as of December 2015, the EBA found that leverage ratios of banks including Deutsche Bank AG, ABN Amro Group NV and Societe Generale SA fell below the 3 percent mark in the adverse scenario of the exam.
In its study, the EBA found that setting a 3 percent requirement produced a capital shortfall of 6.4 billion euros ($7.1 billion) among the 246 entities in its sample. The gap increased to 84.9 billion euros at 4 percent and to as much as 281.6 billion at 5 percent, it said. The larger banks are, on average, more leveraged than the smaller ones, while current leverage ratios vary considerably depending on the business model, it said.
“The results suggest that introducing a flat level of the LR which would apply to all credit institutions would impact business models in profoundly different ways,” the report said.
The EBA and the commission are working on implementing the leverage ratio in parallel with the Basel Committee on Banking Supervision, which plans to complete work on the rules by the end of this year.