The leverage ratio of banks indicates the financial position of the bank in terms of its debt and its capital or assets and it is calculated by Tier 1 capital divided by consolidated assets where Tier 1 capital includes common equity, reserves, retained earnings and other securities after subtracting goodwill.
In simple words, it is a metric used to evaluate the level of debts possessed by the company and access its capability to repay its financial obligations? This ratio assumes additional significance for a bank as a bank is a highly levered entity. A Bank’s capital signifies its net worth (Assets – Liabilities) and is majorly split between two categories: Tier 1 and 2.
The Tier 1 capital for a bank is its core capital and includes items that you will traditionally see on a Bank’s balance sheet. The Tier 2 capital is a supplementary type and mostly includes all the other forms of a bank’s capital, which include undisclosed reserves, revaluation reserves, hybrid instruments, and subordinated term debt. A bank’s total capital is the sum of Tier 1 and Tier 2 capital.
Hence, the Tier 1 capital is naturally more indicative of whether a bank can sustain bankruptcy pressure and is the majorly used item to calculate the leverage ratios for a bank.
This ratio measures the amount of core capital a bank has in relation to its total assets and was introduced to keep a check on the amount of leverage a bank possesses and reinforce the risk-based requirements through the use of a back-stop safeguard measure.
If a bank lends $10 for every $1 of capital reserves, it will have a capital leverage ratio of 1/10 = 10%
Globally, it is required that this ratio is at least 3%, according to the Basel III standards, though country-wise regulations may vary.
For Example – In Dec 2017, JP Morgan reported a Tier 1 capital of $184,375m and an asset exposure of $2,116,031m, which resulted in its Tier 1 Leverage ratio is 8.7%, well above the minimum requirement.
This measurement metric was introduced in the aftermath of the Global Financial Crisis in 2008 and served as the most important ratio when it comes to assessing the health of a Bank.
Other commonly used Leverage ratios are
This ratio measures the amount of financing a company has raised from debt versus equity. A D/E ratio of 0.4 means that for every $1 raised in equity, the company raises $0.4 in debt. Although a very high D/E ratio is generally undesirable, banks tend to have a high D/E ratio because banks carry huge amounts of debt on their balance sheet as they have a significant investment in fixed assets in the form of branch network
Similar to the Debt to Equity Ratio, the Debt to Capital Ratio gives an indication of the amount of debt possessed by a bank in relation to its total capital. Again, this is usually higher for a bank because of its operations, which creates a higher exposure to loans. A bank with a debt of $1000m and an Equity of $2000m will have a Debt to Capital Ratio of 0.33x but a D/E ratio of 0.5x
Leverage ratios are a powerful medium to gauge the effectiveness of a bank, whose entire business depends on the lending of funds and paying off the interest on deposits. A careful investigation of these ratios will reveal not just the debt-paying capacity of the bank, but also how a bank manages its funds and recognizes profits.
This article has been a guide to Leverage Ratios for Banks. Here we discuss the 3 major Leverage Ratios, which include 1) Tier 1 Leverage Ratio, 2) Debt to Equity Ratio, and 3) Debt to Capital Ratio. Here are the other articles in Financial Analysis that you may like –