October 31, 2014
Leverage Ratios in Bank Capital Requirements
This In Focus provides a summary of leverage ratios used
in bank capital requirements. It also explains the concept of
leverage and the rationale behind a leverage ratio.
Leverage and the Financial Crisis
What Is Leverage? A firm or individual can use debt
(borrow) or their own funds (capital) to purchase assets.
Generally, leverage is the use of debt, and increasing the
use of debt relative to capital is referred to as becoming
Why Are Banks Leveraged? In the simplest form of
banking, a bank takes in deposits and uses them to make
loans. This is leveraged finance because the bank is using
debt (deposits) to acquire assets (loans). Banks can also use
capital to fund loans, but if the rate of return paid on capital
is higher than the rate paid to depositors, it would be less
costly for a bank to finance its activities with deposits.
Why Was Leverage an Issue in the Financial Crisis? A
financial firm may use leverage to reduce its funding costs.
But if assets fall in value, financial firms need capital to
absorb those losses. Greater leverage means firms have less
capital relative to assets, and therefore have relatively less
ability to absorb losses before failing.
Many economists view excessive leverage as a contributing
factor to the severity of the crisis. Leveraged losses
depleted capital, causing investors to fear that firms might
fail, making them unwilling to provide firms with more
debt or capital. Firms were forced to sell assets—thereby
further depressing the prices of assets—or reduce lending in
order to reduce leverage (“deleverage”). Deleveraging
reduced the availability of credit for businesses and
households, thereby increasing the severity of the recession.
What Role Did Off-Balance Sheet Exposures Play in the
Crisis? Some financial firms used off-balance sheet
activities such as credit derivatives in which the bank is
selling protection and credit guarantees. These increased
risk exposures in ways that investors could not easily detect
beforehand and, in some cases, allowed firms to become
more leveraged. Subsequent losses caused by off-balance
sheet exposures contributed to an atmosphere of uncertainty
and unwillingness to lend or invest that spiraled into
Basel III Changes to the Leverage Ratio
What Is Basel III? In response to the crisis, 27 countries
agreed in 2010 to modify the Basel Accords, shared bank
regulatory standards. The agreement, known as “Basel III,”
included modifications to capital requirements, which U.S.
bank regulators implemented through rulemaking in 2013.
For more information, see CRS Report R42744, U.S.
Implementation of the Basel Capital Regulatory
What Are Bank Capital Requirements? As part of U.S.
safety and soundness regulation, banks are required to
maintain various capital-to-asset ratios, one of which is the
leverage ratio. If banks fail to meet these ratios, regulators
must take prompt corrective action.
How Is Leverage Defined in Capital Requirements? The
leverage ratio has a specific meaning in capital
requirements. It is the ratio of Tier 1 capital (with certain
adjustments) to consolidated assets. Tier 1 capital is highquality, loss-absorbing forms of capital, such as common
equity. (Basel III tightened the definition of Tier 1 capital.)
Unlike other regulatory capital ratios, assets are not riskweighted for purposes of the leverage ratio.
How Did Basel III Change the Leverage Ratio? The rule
implementing Basel III raised the minimum leverage ratio
from 3% to 4% for certain banks, including those with a
strong supervisory rating. (Banks that did not have a strong
supervisory rating were already required to maintain a 4%
leverage ratio.) In other words, the value of the bank’s Tier
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
least 5% to be considered well capitalized, however.
Why Have Both a Leverage Ratio and Risk-Weighted
Capital Ratios? Basel III measures most capital ratios in
terms of “risk-weighted assets” to account for the fact that
some assets are riskier than others. To determine how much
capital is needed, each asset is assigned a risk weight; assets
with higher risk weights require more capital. For example,
if an asset received a 50% risk weight, half of its value
would be included in the denominator of a capital ratio.
A basic tenet of finance is that riskier assets have a higher
expected rate of return in order to compensate the investor
for bearing more risk. Without risk weighting, banks would
have an incentive to hold riskier assets since the same
amount of capital must be held against riskier and safer
assets. But risk weights may prove inaccurate. For example,
banks held highly rated mortgage-backed securities (MBSs)
before the crisis, in part because those assets had a higher
expected rate of return than other assets with the same risk
weight. MBSs then suffered unexpectedly large losses
during the crisis. Thus, the leverage ratio can be thought of
as a backstop to ensure that incentives posed by riskweighted capital ratios to minimize capital and maximize
risk within a risk weight do not result in a bank holding
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Leverage Ratios in Bank Capital Requirements
The leverage ratio is simpler and more transparent than
risk-weighted capital measures because the public does not
have full information on the risk weight assigned to each
asset held by the bank. Therefore, the public can less easily
assess whether a bank has enough capital to absorb
potential losses based on risk-weighted ratios. Policymakers
concluded that boosting simpler measures of capital was
better at restoring confidence during the crisis.
Who Is Subject to this Rule? The Basel III rule applies to
all banks currently facing U.S. capital requirements.
When Does this Rule Come into Effect? The rule came
into effect on January 1, 2014, for U.S. banks with over
$700 billion in assets or $10 trillion in assets under custody
(currently, only eight U.S. banks qualify), and will come
into effect on January 1, 2015, for all other banks.
How Many Banks Already Meet the Rule? The
regulators estimated that over 95% of banks already met all
of the Basel III capital ratios when the rule was finalized.
Of the banks not currently in compliance, the regulators did
not specify how many failed to meet the leverage ratio. The
figure illustrates that on average banks hold far more capital
than required by the leverage ratio.
Leverage Ratio (%)
Leverage Ratio: Average Actual vs. Required
<$100M $100M to
leverage ratio because small banks on average have fewer
off-balance sheet exposures.
Why Have a Leverage Ratio and a Supplementary
Leverage Ratio? The SLR is intended to ensure that the
bank is adequately safeguarded against off-balance sheet
losses that are not captured in the leverage ratio. Regulators
estimated that a SLR of 3% is equivalent to a leverage ratio
of 4.3%, on average. Thus, the 6% SLR (equivalent to an
8.6% leverage ratio, on average) required for the eight
largest banks to be well capitalized is higher than the 5%
leverage ratio applying to other banks.
Why Have Some Economists Called for Leverage Ratios
to Be Raised for Large Banks? While large banks already
face added capital requirements, including the SLR, some
argue that the “too big to fail” (TBTF) problem should be
addressed by requiring the largest banks to hold more
capital, with some focused specifically on leverage. This
approach could have two advantages. First, holding more
capital reduces the likelihood that losses will lead to
insolvency and systemic instability. Second, if their TBTF
status results in lower funding costs than other banks,
higher capital requirements could, in principle, help “level
the playing field” by raising their funding costs.
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.
Do Banks Currently Hold Enough Capital to Meet the
SLR? As of the second quarter of 2014, regulators
estimated that the eight banks would need to raise $14.5
billion of capital in total to comply with the rule.
Leverage Ratio in the Dodd-Frank Act
Who Is Subject to the Provision? The Dodd-Frank Act
(P.L. 111-203) requires heightened prudential standards for
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
Oversight Council (FSOC), a council of regulators. The
heightened prudential standards include a leverage ratio.
Bank Size (Assets)
Source: CRS based on FDIC data for first half of 2014
Supplementary Leverage Ratio
How Is the Supplementary Leverage Ratio Defined?
Basel III introduced a supplementary leverage ratio (SLR)
for the first time. The SLR also uses Tier 1 capital in the
numerator and unweighted assets in the denominator. The
difference between the leverage ratio and the SLR is that
the SLR includes off-balance sheet exposures in the
denominator. Thus, the numerator is the same, but the
denominator is larger. U.S. regulators set the SLR at 3%,
but banks must maintain a 5% SLR to avoid restrictions on
capital distributions and discretionary bonuses, and 6% for
depository subsidiaries to be considered well capitalized.
Who Is Subject to this Rule? This rule applies to U.S.
banks with over $700 billion in assets or $10 trillion in
assets under custody. Currently, only eight of the largest
banks meet the criteria. According to the regulators, there is
less need to subject small banks to the supplementary
How Is It Calculated? The Dodd-Frank Act limits the ratio
of liabilities to capital at 15 to 1. Unlike the two ratios
discussed above, the Dodd-Frank ratio is based on liabilities
instead of assets. It is calculated as total liabilities relative
to total equity capital minus goodwill. This ratio is inverted
compared to the other two ratios—capital is in the
numerator rather than the denominator.
When Does It Come into Effect? The ratio is only applied
if a bank receives written warning from FSOC that it poses
a “grave threat to U.S. financial stability.” At this time, the
FSOC has not identified any bank as posing a grave threat.
Rulemaking to implement the 15 to 1 leverage ratio for
non-bank SIFIs has not yet been proposed.
Marc Labonte, email@example.com, 7-0640
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