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Unlike [[leveraged alpha]] or the verb [[leverage]], a concept that actually means something. | {{anat|crr}} | ||
Unlike [[leveraged alpha]] or the verb [[leverage]], a concept that actually means something. Per the [[BIS]] Working Paper No. 586: [https://www.bis.org/publ/work586.pdf Leverage and Risk Weighted Capital Requirements]: | |||
The global financial crisis highlighted the limitations of [[risk-weighted assets|risk-weighted]] bank [[capital ratio]]s ([[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]]=== | |||
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]]: | 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.'' | |||
===See also=== | ===See also=== | ||
*[[Leverage ratio denominator]] | *[[Leverage ratio denominator]] | ||
*[[Risk-weighted assets]] | |||
*[[Capital ratio]] | |||
*[[Regulatory capital]] | |||