Leverage means the relative size of an institution’s assets compared to that institution’s own funds. Need to say the banks are highly leveraged institutions as most of the funds are taken from bank’s clients. So banks use client’s money for their deals.
The financial crisis in 2007 – 2008 like other crisis in the past was partly blamed on excessive leverage and thus Leverage ratio became part of Basel III regulation and was defined as follows:
(Tier1) Leverage ratio = Tier 1 Capital / Total exposure (Consolidated Assets)
Tier 1 capital represents a bank’s common equity, retained earnings, reserves, and certain instruments with discretionary dividends and no maturity.
The difference between capital ratio and leverage ratio is the capital ratio measures the bank’s core capital against its risk-weighted assets, however leverage ratio use all including risk non-weighted assets.
A bank’s total exposure measure is the sum of the items:
- On-balance sheet exposures
- Derivative exposures
- Securities finance transactions
- Off-balance sheet items
The regulation aims to reduce excessive leverage, because it may have a negative effect on banks’ solvency.
The banks are expected to maintain a leverage ratio in excess of 3% under Basel III and this value is required for European banks, however for example U.S. banks are required to achieve 5% eventually 6% (depending on size and type of banks like commercial, savings and investment one).
As at the end of 2017 Czech banking sector reported leverage ratio values of 6,5%.
A limitation of using the tier 1 leverage ratio is that investors are reliant on banks to properly calculate and report their tier 1 capital and total assets figures. If a bank doesn’t report or calculate their figures properly, the leverage ratio could be inaccurate. Also, it’s considered that banks have sufficient capital with a leverage ratio above 3% (EU Banks) resp. 5% (US Banks), but we won’t know until the next financial crisis to find out whether banks are truly able to withstand a financial shock or crisis.