Leverage ratio
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Regulatory Capital Anatomy™
The JC’s untutored thoughts on how bank capital works.
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Unlike leveraged alpha or the verb leverage, a concept that actually means something. Per the BIS Working Paper No. 586: Leverage and Risk Weighted Capital Requirements:
The global financial crisis highlighted the limitations of risk-weighted bank capital ratios (regulatory capital divided by risk-weighted assets). Despite refinements over two decades, the weights applied to asset categories did not fully reflect banks’ portfolio risk, in turn increasing systemic risk. To tackle this problem Basel III introduced a minimum leverage ratio, defined as a bank’s tier 1 capital over an exposure measure which is independent of any risk assessment.
Leverage ratio vs. risk weighting
Risk-weighting is (supposedly) a sophisticated tool, leverage ratio a blunt one. Risk-weighting makes a qualitative evaluation of the riskiness of a given asset — apples and pears. LRD applies across the board, to apples and pears equally irrespective of their riskiness.
The aim of the leverage ratio is to complement and backstop risk-based capital requirements, counterbalancing systemic risk by limiting risk weight compression during booms. The leverage ratio is therefore intended to act counter-cyclically — being tighter in booms and looser in busts, thereby reducing the probability of crises and the amplitude of output fluctuations.
The leverage ratio indicates the maximum loss that can be absorbed by equity, while the risk-based requirement refers to a bank’s capacity to absorb potential losses.
From the Basel Committee on Banking Supervision:
- An underlying cause of the global financial crisis was the build-up of excessive on- and off-balance sheet leverage in the banking system. In many cases, banks built up excessive leverage while apparently maintaining strong risk-based capital ratios. At the height of the crisis, financial markets forced the banking sector to reduce its leverage in a manner that amplified downward pressures on asset prices. This deleveraging process exacerbated the feedback loop between losses, falling bank capital and shrinking credit availability.