Leverage Ratios in Bank Capital Requirements

Leverage Ratios in Bank Capital Requirements

Updated December 9, 2015
Leverage Ratios in Bank Capital Requirements
This In Focus provides a summary of leverage ratios used
Implementation of the Basel Capital Regulatory
in bank capital requirements. It also explains the concept of
Framework, by Darryl E. Getter.
leverage and the rationale behind a leverage ratio.
What Are Bank Capital Requirements? As part of U.S.
Leverage and the Financial Crisis
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
What Is Basel III? In response to the crisis, 27 countries
as a backstop to ensure that incentives posed by risk-
agreed in 2010 to modify the Basel Accords, shared bank
weighted capital ratios to minimize capital and maximize
regulatory standards. The agreement, known as “Basel III,”
risk within a risk weight do not result in a bank holding
included modifications to capital requirements, which U.S.
insufficient capital.
bank regulators implemented through rulemaking in 2013.
For more information, see CRS Report R42744, U.S.
The leverage ratio is simpler and more transparent than
risk-weighted capital measures because the public does not
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Leverage Ratios in Bank Capital Requirements
have full information on the risk weight assigned to each
because small banks on average have fewer off-balance
asset held by the bank. Therefore, the public can less easily
sheet exposures.
assess whether a bank has enough capital to absorb
potential losses based on risk-weighted ratios. Policymakers
Why Have a Leverage Ratio and a Supplementary
concluded that boosting simpler measures of capital was
Leverage Ratio? The SLR is intended to ensure that the
better at restoring confidence during the crisis.
bank is adequately safeguarded against off-balance sheet
losses that are not captured in the leverage ratio. Regulators
Who Is Subject to this Rule? The Basel III rule applies to
estimated that a SLR of 3% is equivalent to a leverage ratio
all banks currently facing U.S. capital requirements.
of 4.3%, on average. Thus, the SLR requires affected banks
to hold more capital on average than the leverage ratio.
When Does this Rule Come into Effect? The rule came
into effect on January 1, 2014, for the eight largest banks,
Why Have Some Economists Called for Leverage Ratios
and on January 1, 2015, for all other banks.
to Be Raised for Large Banks? While large banks already
face added capital requirements, including the SLR, some
How Many Banks Already Meet the Rule? The
argue that the “too big to fail” (TBTF) problem should be
regulators estimated that more than 95% of banks already
addressed by requiring the largest banks to hold more
met all of the Basel III capital ratios when the rule was
capital, with some focused specifically on leverage. This
finalized. Of the banks not currently in compliance, the
approach could have two advantages. First, holding more
regulators did not specify how many failed to meet the
capital reduces the likelihood that losses will lead to
leverage ratio. The figure illustrates that on average banks
insolvency and systemic instability. Second, if their TBTF
hold far more capital than required by the leverage ratio.
status results in lower funding costs than other banks,
higher capital requirements could, in principle, help “level
Figure 1. Leverage Ratio: Average Actual vs. Required
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
Source: CRS based on FDIC data for first half of 2014
banks with more than $50 billion in assets and non-banks
that have been designated as “systemically important
Supplementary Leverage Ratio
financial institutions” (SIFIs) by the Financial Stability
How Is the Supplementary Leverage Ratio Defined?
Oversight Council (FSOC), a council of regulators. The
Basel III introduced a supplementary leverage ratio (SLR)
heightened prudential standards include a leverage ratio.
for the first time. The SLR also uses Tier 1 capital in the
numerator and unweighted assets in the denominator. The
How Is It Calculated? The Dodd-Frank Act limits the ratio
difference between the leverage ratio and the SLR is that
of liabilities to capital at 15 to 1. Unlike the two ratios
the SLR includes off-balance sheet exposures in the
discussed above, the Dodd-Frank ratio is based on liabilities
denominator. Thus, the numerator is the same, but the
instead of assets. It is calculated as total liabilities relative
denominator is larger.
to total equity capital minus goodwill. This ratio is inverted
compared to the other two ratios—capital is in the
Who Is Subject to this Rule? All banks with at least $250
numerator rather than the denominator.
billion in total assets and $10 billion in foreign assets must
meet an SLR of 3%. In addition, banks with more than
When Does It Come into Effect? The ratio is only applied
$700 billion in assets or $10 trillion in assets under custody
if a bank receives written warning from FSOC that it poses
must maintain a 5% SLR to avoid restrictions on capital
a “grave threat to U.S. financial stability.” At this time, the
distributions and discretionary bonuses, and 6% for
FSOC has not identified any bank as posing a grave threat.
depository subsidiaries to be considered well capitalized.
Rulemaking to implement the 15 to 1 leverage ratio for
Currently, only eight of the largest banks meet the latter
non-bank SIFIs has not yet been proposed.
criteria. According to the regulators, there is less need to
subject small banks to the supplementary leverage ratio
Marc Labonte, Specialist in Macroeconomic Policy
IF10205

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Leverage Ratios in Bank Capital Requirements

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