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The bank leverage ratio: Quality is just as important as quantity

One of the lessons that the financial crisis of the last few years has taught us is that financial institutions’ capability to generate capital based only on the risk they assume is not sufficient condition for their survival. It is essential to have a magnitude that measures the quality of said capital and its actual capacity to absorb losses. It is in this context that the leverage ratio concept arises, a complementary measure that reinforces the capital requirements regardless of the risk assumed, which can be calculated easily and whose homogeneity allows to compare institutions better.

Photograph leverage ratio

How did the leverage ratio come about?

One of the causes behind the current global financial crisis was the excessive level of leverage of the financial sector. In other words, the relationship between the financing a bank needs to lend to its customers and its equity, or the amount of capital a financial institution obtains from its creditors for every euro of equity.

We should remember that a bank finances its assets (loans granted) by means of its equity (capital) and its interest-bearing liabilities (debt and deposits). Therefore, a way to control its level of leverage would be requiring more capital to finance the assets.

However, pre-crisis regulations considered that to measure the financial health of an institution, all that was needed was for this institution to keep a specific percentage of equity, based on its Risk Weighed Assets (RWAs)  without considering how deep in debt the institution was.

Later, the crisis prove that the capital required through this ratios was not sufficient to ensure that potential losses could be absorbed, as the combination of the different risk assessment models allowed banks to calculate very low RWA figures. Therefore, many institutions appeared to have very high capital ratios, but not because they had enough capital, but because the denominator (RWAs) did not accurately reflect the risk that their balance sheets incorporated.  This allowed them to become excessively indebted without sounding the alarms, until the crisis reached a point where they were forced to engage in highly aggressive deleveraging processes, which generated a vicious cycle of losses, capital losses and loan reduction.

How is the leverage ratio calculated?

In this scenario, the Basel Committee considered it convenient to introduce a ratio to complement the traditional capital ratios, capable of offering a measure of an institution’s capital quality. This was how the leverage ratio came about, which can be easily and transparently calculated, and which allows establishing comparisons between different institutions. Also, in October 2015, the European Commission adopted the definition of the leverage ratio in line with the Basel standards.

The leverage ratio is the quotient between the required Level 1 (or CET1) regulatory capital and the total bank assets (including those that are not in the balance). With this ratio, the regulator aims to achieve two objectives:

  • On one hand, to limit the excess of debt that an institution can take on,
  • and also, to offer a complementary measure that reinforces capital requirements regardless of risk.

Among the advantages of this ratio (besides the already mentioned ones, i.e. ease of calculation and comparability), one of the most notable is that it covers all the risks incurred by an institution. Also, it allows setting limits to the level of risk a bank can take on, regardless of whether its assets have or have not been properly weighed, preventing it from growing the assets in its balance sheet uncontrolledly.

The combination of the leverage ratio with risk weighed capital ratios yield benefits that may be critical in order to prevent future financial crises from happening: It allows reducing systemic risk, ensures the coverage of all the risks of an institution and reduces the capability of banks to engage in excessively risky activities.  Thus, institutions with high risk-weighted asset levels are subject to the restriction of increasing capital to comply with regulatory requirements, while those with low NWAs will be constrained by the leverage ratio.

Photo leverage

What leverage ratio do regulators require?

Basel III established a minimum leverage ratio of 3% for 2018, which means that the capital should be enough to cover 3% of the total assets. In December 2015, BBVA posted a fully loaded leverage ratio (i.e. which incorporates the demands of the regulator for 2018, although with current data) of 6.0%, the highest among its peer group. The sector’s average in September 2015 stood at 4.5%.