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What is SLR and how is it calculated?

By Beth Shah
09 Jan 2015

Since the 2008 financial crisis, global regulators and politicians have embarked on a vast overhaul of the derivatives markets in a bid to reduce systemic risk. Limits on leverage, through the supplementary leverage ratio (SLR), are the heart of the reforms, and market participants are experiencing its profoundly disruptive effects. Beth Shah reports on what SLR is and why it matters.

The Supplementary leverage ratio (SLR) was introduced by the Basel Committee in 2010 and finalised in January 2014 at the international level. A major part of Basel III, it is driving banks to examine how they hold their derivatives exposures.  

Mariam Rafi, head of OTC clearing for Americas at Citigroup, tells GlobalCapital that SLR is calculated as tier one capital, divided by the sum of a bank’s on-balance sheet assets and specific off-balance sheet assets, including derivatives exposures. 

This means it is a capital adequacy measure that ignores the risk intensity of assets, and whether these are included in the bank’s accounting balance sheet. Banks must hold a minimum 3% tier one leverage ratio from 2018, but must report it now.

Bringing in a tough leverage ratio will tend to increase the risk intensity of bank balance sheets.

Oliver Ireland, partner at Morrison & Foerster, notes that if SLR is binding on a bank it discourages firms from holding high quality and low yielding assets because they are taxed by the leverage capital charge just as high risk/high yield assets are taxed.

“So SLR is potentially going to create incentives for banks to adjust their balance sheets in order to deal with it,” says Ireland. “A bank can try to reduce its SLR or increase its yield on the assets which are subject to the SLR. It makes figuring out where to put your money significantly more complicated each time you add in an additional capital calculation that works in a different way, like the supplementary leverage ratio.”

Potential exposure

Measuring exposures is straightforward for cash instruments, but challenging for derivatives. As there is no easy or intuitive way to add up the exposure of a trade which might run for years into the future, derivative exposures in SLR are calculated as the replacement cost of the derivative, plus potential future exposure.

The last part is very difficult, but Basel rules lay out how it should work. Potential future exposure is calculated using the current exposure method (CEM): a grid-based methodology driven by the notional amount, that gives only partial offsets for netting, according to Rafi.

“Under Basel III, banks must hold the greater of capital requirements as calculated under risk-based capital and non-risk based capital metrics,” Rafi says. “The current implementation of SLR requirements (using the CEM calculation) in many instances increases the capital requirements for certain business lines significantly. 

“SLR requirements are also hard to control, given their non-risk based nature,” says Rafi. “CEM methodology is particularly punitive for large notional portfolios with many line items, as very little credit is given for offsetting long and short positions.” She adds that certain asset classes, such as credit derivatives and commodities, also face large haircuts.

Banks must apply the SLR calculation to exposures created by trading as a principal, and against the client-facing leg of trades when acting as a client clearer.

Rafi says that large, internationally active banks need to maintain an SLR ratio of at least 5% at the bank holding company level, and 6% at the bank level, because global systemically important banks (G-SIBs) need a 2% buffer over the  3% minimum ratio. If a US G-SIB’s SLR falls below 5%, it will be subject to increasingly stringent restrictions on making capital distributions and discretionary bonuses.

“We have all kinds of capital requirements floating around so the question becomes which are the ratios that are going to be most binding on a bank, i.e. which one is going to be the tightest constraint given a firm’s asset liability mix,” says Ireland. “Therefore, banks may wind up adjusting their balance sheet to deal with that.”

Compression can help

As CEM is based on notional volumes, not net risk positions, compression, which reduces notional exposure, can control SLR. So banks looking to cut their SLR are turning to compression techniques to ratchet down the individual number of swap trades on their books, as well as the overall notional amount that they have outstanding.

“Compression will minimise SLR requirements for sellside, and optimise operational efficiencies for both the buyside and sellside,” Rafi says. “Accordingly, many banks are now asking clients to compress portfolios and reduce line items in order to minimise SLR requirements. Vendors and CCPs have introduced a variety of products and services to aid clients and dealers in compression portfolios, which will lead to increased operational sustainability both at buy and sellside levels.”

When a firm has fewer line items to manage, it needs less capital to meet its leverage ratio needs, but it also helps it to conduct a timely default management exercise. If a client becomes insolvent, and a bank has fewer line items exposed to that client, it is much easier to macro hedge, terminate and eliminate the risk.

By Beth Shah
09 Jan 2015