Introduction to Bank Regulation: Leverage and Capital Ratio Requirements

Introduction to Bank Regulation: Leverage and Capital Ratio Requirements

link to page 1

Updated January 11, 2019
Introduction to Bank Regulation: Leverage and Capital Ratio
Requirements
Banks generally must comply with a variety of
Section 201 of the Economic Growth, Regulatory Relief,
requirements to hold minimum levels of capital. These
and Consumer Protection Act of 2018 (P.L. 115-174)
requirements are designed to create certain benefits (e.g.,
created an option for banks with less than $10 billion in
fewer bank failures, more systemic stability) but impose
assets to meet a higher leverage ratio—the Community
certain costs (e.g., greater bank funding cost, reduced credit
Bank Leverage Ratio—in order to be exempt from having
availability). Recent legislative changes have led regulators
to meet the risk-based ratios described in the following
to propose rules that would alter a number of capital
paragraph. Bank regulators have issued a proposal to
requirements. This In Focus provides a brief overview of
implement this provision wherein banks below the $10
these requirements and examines related policy issues.
billion threshold that meet at least a 9% ratio of equity and
certain retained earnings to assets and had limited off-
Background
balance sheet exposures and limited securities trading
A bank’s balance sheet is composed of assets, liabilities,
activity (among other requirements) would qualify for the
and capital. A bank is exposed to potential losses on its
exemption.
assets, and its liabilities subject it to payment obligations to
depositors and creditors. Capital instruments—unlike
Risk-weighted Ratio. A risk-weighted ratio assigns a
liabilities—generally do not require payment of a specified
weight—a percentage based on the riskiness of the asset
amount of money at a specified time. Thus, capital gives the
that the asset value is multiplied by—to reflect the fact that
bank the ability to absorb losses while continuing to meet
some assets are more likely to lose value than others.
its rigid obligations on liabilities and avoid failure. To
Riskier assets receive a higher risk weight, and thus banks
decrease the likelihood of bank failures and to minimize
must hold more capital against these assets.
taxpayer exposure, regulators generally require banks to
meet a regulatory ratio requirement—i.e., to hold a
Figure 1. Simplified Example Calculation
minimum level of capital expressed as ratios between items
on bank balance sheets.
Current Requirements
Banks must satisfy several different capital ratio
requirements. A detailed examination of how these ratios
are calculated is beyond the scope of this In Focus. (For a
highly simplified example, see Figure 1.) Broadly
speaking, capital ratios are one of two main types—a
leverage ratio or a risk-based capital ratio.
Leverage Ratio. A leverage ratio treats all assets the same,
meaning banks must hold the same amount of capital

against an exposure regardless of how risky the exposure is.
Source: CRS.
All banks must maintain at least a minimum 4% leverage
All banks are required to maintain at least a 4.5% risk-
ratio of assets to a capital measure that includes equity,
weighted ratio of equity and retained earnings, and ratios of
retained earnings, and other loss-absorbing balance sheet
6% and 8% for capital measures that include additional
items. To be considered “well capitalized”—which lowers a
loss-absorbing instruments. (To be considered well
bank’s FDIC assessment fees, among other benefits—a
capitalized, banks must maintain an additional 2% above
bank must maintain a 5% leverage ratio. Furthermore, 19
the minimum for those measures, raising them to 6.5%, 8%,
large and complex U.S. banks classified as advanced
and 10%, respectively.) To avoid limitations on capital
approaches banks must maintain a minimum 3%
distributions (such as dividend payments), banks must hold
supplementary leverage ratio (SLR) that uses an exposure
an additional 2.5% of high-quality capital on top of the
measure that includes both balance sheet assets and certain
minimum level, called the capital conservation buffer
other exposures to losses that do not appear on the balance
(CCB). In addition, advanced approaches banks could be
sheet. Finally, a subset of eight of the largest and most
subject to a 0-2.5% countercyclical buffer that can be
complex U.S. banks classified as globally systemically
deployed by the Federal Reserve (the Fed) if credit
important banks (G-SIBs) must meet an enhanced SLR
conditions warrant increasing capital (the buffer is currently
(eSLR) requirement of 5% at the holding company level
and always has been set at 0%). Finally, the G-SIBs are
and 6% at the depository level.
subject to an additional capital surcharge of between 1%
https://crsreports.congress.gov

Introduction to Bank Regulation: Leverage and Capital Ratio Requirements
and 4.5% based on the systemic importance of the
risk weights. MBSs subsequently suffered unexpectedly
institution.
large losses.
Broad Policy Considerations
There is also debate as to whether compliance with a risk-
Because capital absorbs losses, minimum requirements play
weighted system involves complexity and costs that could
a more prominent role in prudential regulation. However,
benefit larger banks with the resources to absorb the added
prudential regulation involves requirements besides capital
regulatory cost compared to small banks that could find
ratios, such as liquidity requirements, asset concentration
compliance more burdensome.
guidelines, and counterparty limits. Some observers assert
that if a bank has sufficient capital in place, it should not be
Appropriate Requirements for Large Banks. As
subject to some of these other regulatory requirements.
previously discussed, as banks get larger and more
However, others believe that the different components of
complex, they face progressively more stringent capital
prudential regulation (of which capital requirements are
requirements. These requirements have been implemented
only one) each play an important role in ensuring the safety
because many observers believe that (1) the largest banks
and soundness of financial institutions and are essential
pose a relatively higher risk to systemic stability than
complements to bank capital.
individual small banks; (2) the largest banks have the
resources and sophistication to comply with additional
Whether the benefits of capital requirements are
requirements without being unduly burdened; and (3)
outweighed by the potential costs is another debated issue.
certain of these banks may enjoy funding advantages due to
Capital is typically a more expensive source of funding for
being “too big to fail” (i.e., investors and creditors do not
banks than liabilities. Thus, requiring banks to hold higher
require returns that fully reflect the risk of the bank’s failure
levels of capital may raise banks’ funding costs, possibly
due to a belief that the government would rescue the bank
affecting the costs and availability of credit. It is possible
before failure). However, whether these additional
this would slow economic growth over a period of time.
requirements are appropriately calibrated is a debated issue.
However, no economic consensus exists on this question,
because a more stable banking system with fewer crises and
Some argue that certain requirements that are set at a fixed
failures may lead to higher long-run economic growth.
number, including the CCB and eSLR, are inefficient
because they do not reflect varying levels of risk posed by
Specific Policy Issues
individual banks. In response to this concern, the Fed has
Appropriate Role of the Two Types of Ratios. The
released proposals for public comment that would link
exemption from risk-based ratio requirements provided by
individual large banks’ CCB requirements with their stress
P.L. 115-174 (and other bills that would make such an
tests results and eSLR requirements with their G-SIB
exemption even more widely available, such as H.R. 10 in
systemic importance score. Opponents of these proposals
the 115th Congress) reflects an ongoing debate about the
assert these changes would relax the capital requirements
prominence that leverage and capital ratios play relative to
facing certain large and profitable banks, and in doing so
each other in the regulatory framework.
needlessly pare back important safeguards against bank
failures and systemic instability.
Some policymakers argue that having both risk-weighted
and leverage ratio requirements is important, because each
In addition, whether the surcharges currently facing U.S. G-
measure addresses certain weaknesses of the other. For
SIBs are too high has been subject to debate. Certain other
example, without risk weighting, banks would have an
countries use methodologies to determine surcharges on
incentive to hold riskier assets because the same amount of
their G-SIBs that would result in lower surcharges for
capital must be held against risky, high-yielding assets and
certain U.S. G-SIBs if implemented here. Some observers
safe, low-yielding assets. In addition, a leverage ratio alone
assert this puts U.S. G-SIBs at a disadvantage and call for
may not accurately reflect a bank’s riskiness because a high
the Fed’s surcharges to be reevaluated and possibly altered
concentration of risky assets could produce a similar ratio
to more closely resemble other countries’ surcharges.
as a high concentration of safe assets.
Opponents of this view argue that the methodology used by
the Fed generally results in appropriate surcharges given the
However, critics of risk-weighted ratios argue their use
size, complexity, and risks posed by the U.S. G-SIBs and
should be limited. Certain risk weights could potentially be
doubt the necessity and prudence of lowering capital
an inaccurate estimation of some assets’ true risk,
requirements for large, currently profitable banks.
especially since they are unlikely to be adjusted as quickly
as risks might change. Furthermore, banks may have an
CRS Resources
incentive to overly invest in assets with risk weights that are
CRS In Focus IF10205, Leverage Ratios in Bank Capital
set too low, or inversely to underinvest in assets with risk
Requirements, by Marc Labonte
weights that are set too high. Some observers believe that
the risk weights in place prior to the 2007-2009 financial
CRS Report R45073, Economic Growth, Regulatory Relief,
crisis were poorly calibrated and encouraged
and Consumer Protection Act (P.L. 115-174) and Selected
overinvestment in risky assets, exacerbating the downturn.
Policy Issues, coordinated by David W. Perkins
For example, banks held many mortgage-backed securities
(MBSs) before the crisis, likely in part because MBSs
David W. Perkins, Analyst in Macroeconomic Policy
offered a higher rate of return than other assets with similar
IF10809
https://crsreports.congress.gov

Introduction to Bank Regulation: Leverage and Capital Ratio Requirements

Disclaimer
This document was prepared by the Congressional Research Service (CRS). CRS serves as nonpartisan shared staff to
congressional committees and Members of Congress. It operates solely at the behest of and under the direction of Congress.
Information in a CRS Report should not be relied upon for purposes other than public understanding of information that has
been provided by CRS to Members of Congress in connection with CRS’s institutional role. CRS Reports, as a work of the
United States Government, are not subject to copyright protection in the United States. Any CRS Report may be
reproduced and distributed in its entirety without permission from CRS. However, as a CRS Report may include
copyrighted images or material from a third party, you may need to obtain the permission of the copyright holder if you
wish to copy or otherwise use copyrighted material.

https://crsreports.congress.gov | IF10809 · VERSION 4 · UPDATED