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The leverage ratio: concerns for lenders


Published: 18 February 2014 | Author: Bernard Clarke

The Basel committee has recently published revised comments on the leverage ratio for banks. The introduction of the ratio is seen a key component of reforms to the regulatory system in the aftermath of the financial crisis, and the committee’s proposals could have important implications for mortgage lenders, in the UK and elsewhere. They are likely to re-open the debate on the impact and effectiveness of the leverage ratio.

Simply put, the leverage ratio is the amount of capital held by a firm divided by its assets. 

17.02.2014 leverage ratio newsandviews

The Basel committee wants lenders to maintain the ratio as an additional layer of regulatory protection, over and above the requirement it imposes on firms to hold capital reflecting the risks associated with different types of assets. The regulator is therefore proposing two sets of rules requiring firms to hold capital. 

The leverage ratio is an inherently non risk-based approach, and some lenders have reservations about the basic concept of requiring firms to hold capital in a fixed ratio to assets, irrespective of their associated risks. 

Its effect is to determine either how much capital a lender must hold for a given amount of assets or, if the firm chooses to operate with a fixed base of capital, to dictate an upper limit for its assets – in effect, controlling its size. 

As ever, the devil is in the detail, partly because the definition of capital or what counts as assets may change the impact of any given ratio. In part, this is what the most recent comments from the Basel committee have sought to clarify. The committee also confirmed its view that the minimum leverage ratio for all lenders should be 3%.

The Bank of England, through the Prudential Regulation Authority, already enforces a ratio of 3%. However, the Independent Commission on Banking suggested a higher ratio, of 4.06% for some lenders. A significantly higher ratio is also used in the US, although the definition there is different to that proposed by the Basel committee or, for that matter, by the Bank of England.

Uncertainty over the definition of the leverage ratio – or future changes in the level at which it was set – could have pronounced effects on the lending industry, on the availability of mortgage credit, and on consumers.

Another concern for lenders is that, while prime mortgage assets are low risk, they are advanced by different types of lending institution.  But the leverage ratio makes no allowance for differences in the types of firm originating mortgages.

Under the Basel rules on risk-weighted capital, lenders whose assets are prime residential mortgages can hold less capital since those assets are less risky than others like, for example, corporate loans. However, since the leverage ratio does not make any allowance for differences in the riskiness of different types of assets, the net affect is that, under some calculations of the ratio, lenders can look under-capitalised (that is, their balance sheet can appear too large for the capital they hold). 

The solution could be either to raise more capital – which could impose costs that are then passed on to the consumer – or to shrink the balance sheet, perhaps by stopping lending or limiting the availability of mortgages.

Both of these options may be undesirable. And there are other potentially unhelpful outcomes. Because the leverage ratio does not recognise the riskiness of assets, firms that are constrained by it may seek to boost their returns by switching some of their assets from less risky mortgages to more risky options, like corporate loans. 

On the other hand, the Basel risk-weighted calculations for capital have produced some equally perverse affects. In the build-up to the financial crisis, some lenders were actively increasing assets with low risk weightings. Subsequently, however, it became apparent that some of these weightings, including, for example, those assigned to Greek government debt, had significantly under-estimated the real level of risk.

What this probably means is that no system of regulation can be regarded as infallible. To be successful and to avoid unintended consequences, the interpretation of regulation must be based on judgement and moderation. In particular, we are concerned that the leverage ratio is seen uncritically as a wholly positive enhancement of the regulatory system. We believe that it could create as many problems as it solves, and could have a significant, detrimental impact on the mortgage industry.

Proposals for a leverage ratio – and other reforms – must also be judged in the context of other regulatory developments. In the UK, for example, the introduction of the mortgage market review this spring will put further restrictions on risks associated with lending activity. 

Other elements of the new regulatory system, like the wide range of powers available to the Bank of England’s financial policy committee, also protect the system from risk and reinforce financial stability. So, the leverage ratio may have a role to play, but our view is that regulators should focus on improving and refining the Basel risk-weighted calculations of capital requirements.