Leverage Ratios in Bank Capital Requirements

Leverage Ratios in Bank Capital Requirements

October 31, 2014
Leverage Ratios in Bank Capital Requirements
bank regulators implemented through rulemaking in 2013.
This In Focus provides a summary of leverage ratios used
For more information, see CRS Report R42744, U.S.
in bank capital requirements. It also explains the concept of
Implementation of the Basel Capital Regulatory
leverage and the rationale behind a leverage ratio.
Framework.
Leverage and the Financial Crisis
What Are Bank Capital Requirements? As part of U.S.
safety and soundness regulation, banks are required to
What Is Leverage? A firm or individual can use debt
maintain various capital-to-asset ratios, one of which is the
(borrow) or their own funds (capital) to purchase assets.
leverage ratio. If banks fail to meet these ratios, regulators
Generally, leverage is the use of debt, and increasing the
must take prompt corrective action.
use of debt relative to capital is referred to as becoming
more leveraged.
How Is Leverage Defined in Capital Requirements? The
leverage ratio has a specific meaning in capital
Why Are Banks Leveraged? In the simplest form of
requirements. It is the ratio of Tier 1 capital (with certain
banking, a bank takes in deposits and uses them to make
adjustments) to consolidated assets. Tier 1 capital is high-
loans. This is leveraged finance because the bank is using
quality, loss-absorbing forms of capital, such as common
debt (deposits) to acquire assets (loans). Banks can also use
equity. (Basel III tightened the definition of Tier 1 capital.)
capital to fund loans, but if the rate of return paid on capital
Unlike other regulatory capital ratios, assets are not risk-
is higher than the rate paid to depositors, it would be less
weighted for purposes of the leverage ratio.
costly for a bank to finance its activities with deposits.
How Did Basel III Change the Leverage Ratio? The rule
Why Was Leverage an Issue in the Financial Crisis? A
implementing Basel III raised the minimum leverage ratio
financial firm may use leverage to reduce its funding costs.
from 3% to 4% for certain banks, including those with a
But if assets fall in value, financial firms need capital to
strong supervisory rating. (Banks that did not have a strong
absorb those losses. Greater leverage means firms have less
supervisory rating were already required to maintain a 4%
capital relative to assets, and therefore have relatively less
leverage ratio.) In other words, the value of the bank’s Tier
ability to absorb losses before failing.
1 capital must be equal to at least 4% of the value of the
bank’s assets. The bank must maintain a leverage ratio of at
Many economists view excessive leverage as a contributing
least 5% to be considered well capitalized, however.
factor to the severity of the crisis. Leveraged losses
depleted capital, causing investors to fear that firms might
Why Have Both a Leverage Ratio and Risk-Weighted
fail, making them unwilling to provide firms with more
Capital Ratios? Basel III measures most capital ratios in
debt or capital. Firms were forced to sell assets—thereby
terms of “risk-weighted assets” to account for the fact that
further depressing the prices of assets—or reduce lending in
some assets are riskier than others. To determine how much
order to reduce leverage (“deleverage”). Deleveraging
capital is needed, each asset is assigned a risk weight; assets
reduced the availability of credit for businesses and
with higher risk weights require more capital. For example,
households, thereby increasing the severity of the recession.
if an asset received a 50% risk weight, half of its value
would be included in the denominator of a capital ratio.
What Role Did Off-Balance Sheet Exposures Play in the
Crisis? Some financial firms used off-balance sheet
A basic tenet of finance is that riskier assets have a higher
activities such as credit derivatives in which the bank is
expected rate of return in order to compensate the investor
selling protection and credit guarantees. These increased
for bearing more risk. Without risk weighting, banks would
risk exposures in ways that investors could not easily detect
have an incentive to hold riskier assets since the same
beforehand and, in some cases, allowed firms to become
amount of capital must be held against riskier and safer
more leveraged. Subsequent losses caused by off-balance
assets. But risk weights may prove inaccurate. For example,
sheet exposures contributed to an atmosphere of uncertainty
banks held highly rated mortgage-backed securities (MBSs)
and unwillingness to lend or invest that spiraled into
before the crisis, in part because those assets had a higher
financial instability.
expected rate of return than other assets with the same risk
weight. MBSs then suffered unexpectedly large losses
Basel III Changes to the Leverage Ratio
during the crisis. Thus, the leverage ratio can be thought of
as a backstop to ensure that incentives posed by risk-
What Is Basel III? In response to the crisis, 27 countries
weighted capital ratios to minimize capital and maximize
agreed in 2010 to modify the Basel Accords, shared bank
risk within a risk weight do not result in a bank holding
regulatory standards. The agreement, known as “Basel III,”
insufficient capital.
included modifications to capital requirements, which U.S.
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Leverage Ratios in Bank Capital Requirements
The leverage ratio is simpler and more transparent than
leverage ratio because small banks on average have fewer
risk-weighted capital measures because the public does not
off-balance sheet exposures.
have full information on the risk weight assigned to each
asset held by the bank. Therefore, the public can less easily
Why Have a Leverage Ratio and a Supplementary
assess whether a bank has enough capital to absorb
Leverage Ratio? The SLR is intended to ensure that the
potential losses based on risk-weighted ratios. Policymakers
bank is adequately safeguarded against off-balance sheet
concluded that boosting simpler measures of capital was
losses that are not captured in the leverage ratio. Regulators
better at restoring confidence during the crisis.
estimated that a SLR of 3% is equivalent to a leverage ratio
of 4.3%, on average. Thus, the 6% SLR (equivalent to an
Who Is Subject to this Rule? The Basel III rule applies to
8.6% leverage ratio, on average) required for the eight
all banks currently facing U.S. capital requirements.
largest banks to be well capitalized is higher than the 5%
leverage ratio applying to other banks.
When Does this Rule Come into Effect? The rule came
into effect on January 1, 2014, for U.S. banks with over
Why Have Some Economists Called for Leverage Ratios
$700 billion in assets or $10 trillion in assets under custody
to Be Raised for Large Banks? While large banks already
(currently, only eight U.S. banks qualify), and will come
face added capital requirements, including the SLR, some
into effect on January 1, 2015, for all other banks.
argue that the “too big to fail” (TBTF) problem should be
addressed by requiring the largest banks to hold more
How Many Banks Already Meet the Rule? The
capital, with some focused specifically on leverage. This
regulators estimated that over 95% of banks already met all
approach could have two advantages. First, holding more
of the Basel III capital ratios when the rule was finalized.
capital reduces the likelihood that losses will lead to
Of the banks not currently in compliance, the regulators did
insolvency and systemic instability. Second, if their TBTF
not specify how many failed to meet the leverage ratio. The
status results in lower funding costs than other banks,
figure illustrates that on average banks hold far more capital
higher capital requirements could, in principle, help “level
than required by the leverage ratio.
the playing field” by raising their funding costs.
Leverage Ratio: Average Actual vs. Required
When Does the SLR Come into Effect? Beginning in
January 2018, banks subject to the rule will be required to

meet the supplemental leverage ratio.
14
) 12
(%

Actual
Do Banks Currently Hold Enough Capital to Meet the
10
SLR? As of the second quarter of 2014, regulators
atio 8
Well

R
estimated that the eight banks would need to raise $14.5
e
Capitalized
6
billion of capital in total to comply with the rule.
ag 4

2
Minimum
Leverage Ratio in the Dodd-Frank Act
Lever

0
<$100M $100M to
$1B to
>$10B
Who Is Subject to the Provision? The Dodd-Frank Act
$1B
$10B

(P.L. 111-203) requires heightened prudential standards for
Bank Size (Assets)
banks with more than $50 billion in assets and non-banks

that have been designated as “systemically important
financial institutions” (SIFIs) by the Financial Stability
Source: CRS based on FDIC data for first half of 2014
Oversight Council (FSOC), a council of regulators. The
heightened prudential standards include a leverage ratio.
Supplementary Leverage Ratio
How Is It Calculated? The Dodd-Frank Act limits the ratio
How Is the Supplementary Leverage Ratio Defined?
of liabilities to capital at 15 to 1. Unlike the two ratios
Basel III introduced a supplementary leverage ratio (SLR)
discussed above, the Dodd-Frank ratio is based on liabilities
for the first time. The SLR also uses Tier 1 capital in the
instead of assets. It is calculated as total liabilities relative
numerator and unweighted assets in the denominator. The
to total equity capital minus goodwill. This ratio is inverted
difference between the leverage ratio and the SLR is that
compared to the other two ratios—capital is in the
the SLR includes off-balance sheet exposures in the
numerator rather than the denominator.
denominator. Thus, the numerator is the same, but the
denominator is larger. U.S. regulators set the SLR at 3%,
When Does It Come into Effect? The ratio is only applied
but banks must maintain a 5% SLR to avoid restrictions on
if a bank receives written warning from FSOC that it poses
capital distributions and discretionary bonuses, and 6% for
a “grave threat to U.S. financial stability.” At this time, the
depository subsidiaries to be considered well capitalized.
FSOC has not identified any bank as posing a grave threat.
Rulemaking to implement the 15 to 1 leverage ratio for
Who Is Subject to this Rule? This rule applies to U.S.
non-bank SIFIs has not yet been proposed.
banks with over $700 billion in assets or $10 trillion in
assets under custody. Currently, only eight of the largest
Marc Labonte, mlabonte@crs.loc.gov, 7-0640
banks meet the criteria. According to the regulators, there is
IF00062
less need to subject small banks to the supplementary
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