Explainer | Why ‘leverage ratio’ is so important for banks

Banks need to be well capitalised to tackle any crisis situation. There are instances galore where the lenders have just failed to make the cut in the past. That explains the criticality of capital and leverage in the scheme of things.

What is a ‘leverage ratio’ for banks?

The Basel Committee on Banking Supervision (BCBS) introduced a leverage ratio in the 2010 Basel III package of reforms.

The leverage ratio is defined as the capital measure divided by the exposure measure, expressed as a percentage. The capital measure is tier 1 capital and the exposure measure includes both on-balance sheet exposure and off-balance sheet items.

What is the purpose of having a leverage ratio?

The leverage ratio measures a bank's core capital to its total assets. The ratio uses tier 1 capital to judge how leveraged a bank is in relation to its consolidated assets. Tier 1 assets are ones that can be easily liquidated if a bank needs capital in the event of a financial crisis. So, it is basically a ratio to measure a bank's financial health.

The higher the tier 1 leverage ratio, the higher the likelihood of the bank withstanding negative shocks to its balance sheet.

The leverage ratio is used as a tool by central monetary authorities to ensure the capital adequacy of banks and place constraints on the degree to which a financial company can leverage its capital base.

Basel III established a 3 percent minimum requirement for the leverage ratio while it left open the possibility of making the threshold even higher for certain systematically important financial institutions.

Why was the leverage ratio introduced?

An underlying cause of the Great Financial Crisis was the build-up of excessive on-and off-balance sheet leverage in the banking system. In many cases, banks built up excessive leverage while maintaining seemingly strong risk-based capital ratios. The ensuing deleveraging process at the height of the crisis created a vicious circle of losses and reduced availability of credit in the real economy.

The BCBS introduced a leverage ratio in Basel III to reduce the risk of such periods of deleveraging in future and the damage they inflict on the broader financial system and economy. How is the Leverage Ratio calculated?

The Formula for the Leverage Ratio is

(Tier 1 Capital/ Total Consolidated Assets) ×100

Tier 1 capital for the bank is placed in the numerator of the leverage ratio. Tier 1 capital represents a bank's common equity, retained earnings, reserves, and certain instruments with discretionary dividends and no maturity.

The denominator in the leverage ratio is a bank's total exposures, which include its consolidated assets, derivative exposure, and certain off-balance sheet exposures. Basel III required banks to include off-balance sheet exposures such as commitments to provide loans to third parties, standby letters of credit, acceptances, and trade letters of credit.

What is the difference between leverage ratio and tier 1 capital adequacy ratio?

The tier 1 capital adequacy ratio (CAR) is the ratio of a bank’s core tier 1 capital—that is, its equity capital and disclosed reserves—to its total risk-weighted assets. It is a key measure of a bank's financial strength that has been adopted as part of the Basel III Accord on bank regulation. It measures a bank’s core equity capital as against its total risk-weighted assets.

The leverage ratio is a measure of the bank's core capital to its total assets. The ratio uses tier 1 capital to judge how leveraged a bank is in relation to its consolidated assets whereas the tier 1 capital adequacy ratio measures the bank's core capital against its risk-weighted assets.

What is the limitation in using leverage ratio?

A limitation of using the leverage ratio is that investors are reliant on banks to properly calculate and report their tier 1 capital and total assets figures. If a bank doesn't report or calculate these figures properly, the leverage ratio could be inaccurate.

What has RBI done in its latest monetary policy move?

RBI has reduced the leverage ratio from 4.5 percent to 4 percent for systemically important banks and 3.5 percent for other banks, which will help them increase exposure.

Will the reduction in leverage ratio lead to higher credit growth?

For well-capitalised banks with CAR much higher than regulatory requirement, it could encourage increasing exposure. However, for capital-starved banks, the additional exposure will have to be of lower risk weights. Otherwise, they will not be able to maintain their CAR while reducing their leverage ratio.