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Adjusted leveraged balance

Adjusted Leveraged Balance: Understanding Bank Exposure in Regulation

What Is Adjusted Leveraged Balance?

The Adjusted Leveraged Balance refers to the comprehensive measure of a bank's total exposures used in the calculation of regulatory Leverage Ratios, particularly under the Basel III framework. It encompasses both on-balance sheet assets and various Off-Balance Sheet exposures, adjusted to reflect their equivalent leverage. This concept is central to Banking Regulation, aiming to provide a non-risk-based backstop to traditional Risk-Weighted Assets requirements, preventing excessive leverage in the financial system. The goal of measuring the Adjusted Leveraged Balance is to capture a more complete picture of a financial institution's total commitments and obligations, which might otherwise be obscured by complex financial instruments.

History and Origin

The concept of an Adjusted Leveraged Balance gained significant prominence following the 2007-2009 Financial Crisis. Prior to this period, banks often maintained seemingly strong capital adequacy ratios based on risk-weighted assets, while simultaneously accumulating substantial off-balance sheet exposures that were not fully captured by existing regulatory frameworks. This hidden leverage contributed to a build-up of systemic risk and exacerbated the crisis when these exposures materialized. Regulators, particularly the Basel Committee on Banking Supervision (BCBS), recognized the need for a simple, non-risk-based measure to complement risk-weighted capital requirements. The Basel III framework, introduced in response to the crisis, integrated a Leverage Ratio designed to constrain excessive leverage and enhance bank stability. This ratio's denominator, the "exposure measure" or "total leverage exposure," effectively became the Adjusted Leveraged Balance, designed to capture all significant on- and off-balance sheet items. Research published by CEPR highlighted how, in the years leading up to the crisis, banks significantly increased leverage both on and, critically, off their Balance Sheets through activities like securitization and derivatives trading, which raised individual bank risk and systemic risk.8

Key Takeaways

  • The Adjusted Leveraged Balance is a key component of regulatory leverage ratios, such as those under Basel III.
  • It aims to capture a bank's total exposure, including significant on- and off-balance sheet items.
  • This measure serves as a non-risk-based backstop to complement traditional risk-weighted capital requirements.
  • Its development was a direct response to the hidden leverage that contributed to the 2007-2009 financial crisis.
  • Accurate calculation of the Adjusted Leveraged Balance is crucial for assessing a bank's true leverage and ensuring financial stability.

Formula and Calculation

The Adjusted Leveraged Balance, often referred to as the "exposure measure" or "total leverage exposure," forms the denominator of the regulatory leverage ratio. While the precise calculation can vary slightly by jurisdiction and specific regulatory body (e.g., the Federal Reserve’s Supplemental Leverage Ratio), the core components typically include:

  • On-balance sheet assets: Generally, the sum of all assets as reported on the bank's Financial Statements, excluding certain deductions (e.g., goodwill).
  • Derivatives exposures: Calculated based on the sum of current mark-to-market replacement costs for contracts with positive value, plus an add-on for potential future exposure. Eligible bilateral netting agreements can reduce this amount, but collateral received generally cannot. This aims to account for counterparty credit risk.
    *7 Securities Financing Transactions (SFTs): These include transactions like repos and reverse repos. The exposure measure for SFTs generally considers the gross amount of exposure.
  • Off-Balance Sheet items: This category includes commitments, guarantees, and other contingent liabilities. Instead of a uniform 100% credit conversion factor (CCF), the leverage ratio typically uses the same CCFs as the standardized approach for credit risk under risk-based requirements, subject to a minimum floor, often 10%.

6The general conceptual formula for the exposure measure (Adjusted Leveraged Balance) can be represented as:

Adjusted Leveraged Balance=On-Balance Sheet Assets+Derivative Exposures (PFE + Replacement Cost)+SFT Exposures+Off-Balance Sheet Items (CCF-adjusted)\text{Adjusted Leveraged Balance} = \text{On-Balance Sheet Assets} + \text{Derivative Exposures (PFE + Replacement Cost)} + \text{SFT Exposures} + \text{Off-Balance Sheet Items (CCF-adjusted)}

Where:

  • On-Balance Sheet Assets refers to the sum of all assets on the bank's consolidated balance sheet.
  • Derivative Exposures includes the sum of replacement cost for derivatives with positive value and a potential future exposure (PFE) add-on.
  • SFT Exposures encompasses the gross value of securities financing transactions.
  • Off-Balance Sheet Items (CCF-adjusted) represents the face value of off-balance sheet items multiplied by their respective Credit Conversion Factors (CCFs).

Interpreting the Adjusted Leveraged Balance

The Adjusted Leveraged Balance itself is not a standalone metric for interpretation but is a critical input into the Leverage Ratio. A larger Adjusted Leveraged Balance, relative to a bank's Tier 1 Capital, indicates higher overall leverage and potentially greater risk. Conversely, a smaller Adjusted Leveraged Balance for a given amount of capital signifies lower leverage. Regulators use this total exposure measure to ensure that banks maintain a minimum level of capital regardless of the perceived riskiness of their assets. This provides a "backstop" to the risk-weighted assets framework, aiming to prevent scenarios where banks might appear well-capitalized under risk-based measures but are actually highly leveraged due to large, often complex, off-balance sheet positions. It is a crude, yet effective, measure of a bank's size and total footprint in the financial system.

Hypothetical Example

Consider a hypothetical bank, "Diversified Financial," with $500 billion in on-balance sheet assets. In addition to these assets, Diversified Financial has significant off-balance sheet exposures:

  • $100 billion in committed credit lines to corporate clients. Under regulatory guidelines, these might have a 50% Credit Conversion Factor (CCF).
  • $50 billion in gross derivatives notional amounts, with a current positive mark-to-market value of $5 billion and a potential future exposure add-on of $2 billion.
  • $30 billion in repurchase agreements (repos).

To calculate Diversified Financial's Adjusted12345