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The RBI relaxes the Leverage Ratio (LR)

What’s in News
Recently, the Leverage Ratio (LR) for banks was relaxed by the Reserve Bank of India (RBI) to help them boost their lending activities.

The central bank said in a notification that LR stands reduced to 4 percent for Domestic Systematically Important Banks (DSIBs) and 3.5 percent for other banks commencing from October 1, 2019.

The concept of Leverage Ratio was introduced by the Basel Committee of Banking Supervision (BCBS) in the year 2010 Basel III package of reforms.

Its purpose is to indicate the debt level incurred by banks.

Banks were supposed to publicly disclose their BASEL III LR on a consolidated basis beginning April 2015.

Leverage Ratio (LR)
•LR, as defined under Basel-III norms, is Tier-I capital as a percentage of the bank’s exposures.

•It is designed to capture leverage associated with both on and off-balance sheet exposures. It serves as a safety net.

•One of the features of the financial crisis of 2008 was the build-up of excessive on and off-balance sheet leverage in the banking system which led to the introduction of LR.

Total Exposure
A bank’s total exposure is defined as the sum of the following exposures: on-balance sheet exposures; derivative exposures; securities financing transaction exposures; and off-balance sheet items.

Tier 1 Capital
•A term used to describe the capital adequacy of a bank—it can absorb losses without a bank being required to cease trading.

•This is the core measure of a bank’s financial strength from a regulator’s point of view (this is the most reliable form of capital).

•It consists of the types of financial capital considered the most reliable and liquid, primarily stockholders’ equity and disclosed reserves of the bank—equity capital can’t be redeemed at the option of the holder and disclosed reserves are the liquid assets available with the bank itself.

Tier 2 Capital
•A term used to describe the capital adequacy of a bank—it can absorb losses in the event of a winding-up and so provides a lesser degree of protection to depositors.

•Tier II capital is secondary bank capital (the second most reliable forms of capital). This is related to Tier 1 Capital.

•This capital is a measure of a bank’s financial strength from a regulator’s point of view. It consists of the accumulated after-tax surplus of retained earnings, revaluation reserves of fixed assets and long-term holdings of equity securities, general loan-loss reserves, hybrid (debt/equity) capital instruments, and subordinated debt and undisclosed reserves

Tier 3 Capital
•A term used to describe the capital adequacy of a bank—considered the tertiary capital of the banks which are used to meet/support market risk, commodities risk, and foreign currency risk.

•It includes a variety of debt other than Tier 1 and Tier 2 capitals.

•Tier 3 capital debts may include a greater number of subordinated issues, undisclosed reserves, and general loss reserves compared to Tier 2 capital.

•To qualify as Tier 3 capital, assets must be limited to 250 percent of a bank’s Tier 1 capital, be unsecured, subordinated and have a minimum maturity of two years.

Bank of International Settlement (BIS)
Established in 1930, the BIS is owned by 60 central banks, representing countries from around the world that together account for about 95% of world GDP.

Its head office is in Basel, Switzerland and it has two representative offices: in Hong Kong SAR and Mexico City.

It works in the area of monetary and financial stability and regularly publishes related analyses and international banking and financial statistics that underpin policymaking, academic research, and public debate.

It hosts and supports a number of international institutions engaged in standard setting and financial stability, one of which is BCBS.

BCBS- Background
Initially named the Committee on Banking Regulations and Supervisory Practices it was established by the central bank Governors of the Group of Ten countries at the end of 1974.

The Committee, headquartered at the Bank for International Settlements in Basel, was established to enhance financial stability by improving the quality of banking supervision worldwide, and to serve as a forum for regular cooperation between its member countries on banking supervisory matters.

BCBS- Importance
It consists of central bankers from 27 countries and the European Union.

It developed a series of policy recommendations, Basel Accords that suggests minimum capital requirements to keep bank solvent during times of financial stress.

RBI issues guidelines based on Basel III reforms.

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