What are Leverage Ratios for Banks?
Leverage ratio for banks indicates its financial position regarding its debt and capital or assets. One may calculate it by Tier 1 Capital divided by consolidated assets, where Tier 1 Capital includes common equity, reserves, retained earnings, and other securities after subtracting goodwill. Minimum leverage ratios for banks help them to have enough liquidity in hand to pass certain stress tests.
In simple words, this is a metric used to evaluate the level of debts possessed by the company and assess 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 worthNet WorthThe company's net worth can be calculated using two methods: the first is to subtract total liabilities from total assets, and the second is to add the company's share capital (both equity and preference) as well as reserves and surplus.read more (assets – liabilities) and is majorly split between two categories: Tier 1 and 2.
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Table of contents
Key Takeaways
- A bank’s leverage ratio displays the economic position concerning the debt and capital or assets.
- To calculate, one must divide Tier 1 Capital by consolidated assets. Tier 1 Capital involves common equity, reserves, retained earnings, and other securities after deducting goodwill.
- A careful ratios investigation shows the debt-paying bank’s capability and funds management. It also identifies its profits.
- It also helps to determine whether the banks can withstand a financial crisis which one would only understand the actual effect once it strikes.
Leverage Ratios For Banks Explained
Leverage rations for banks is a clear indicator of the financial health of a bank. It is the capital in the bank its assets. Ideal leverage ratios for banks increase the creditworthiness of a bank significantly.
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Tier 1 Capital is its core capital and includes items you will traditionally see on a bank’s balance sheet. The Tier 2 CapitalThe Tier 2 CapitalTier 2 capital, also known as supplementary capital, is the second layer of bank capital requirements. It consists of hybrid instruments, general provisions and revaluation reserves. Uneasy to liquidate; Tier 2 capital is considered less secure.read more is a supplementary type and mostly includes all the other forms of a bank’s capital, including undisclosed reserves, revaluation reserves, hybrid instruments, and subordinated term debtSubordinated Term DebtIn case of liquidation of a company, rankings are provided to various debts for repayment, wherein the kind of debt which is ranked after all the senior debt and other corporate Debts and loans is known as subordinated debt, and the borrowers of such kind of debt are larger corporations or business entities.read more. 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.
Leverage ratiosLeverage RatiosDebt-to-equity, debt-to-capital, debt-to-assets, and debt-to-EBITDA are examples of leverage ratios that are used to determine how much debt a company has taken out against its assets or equity.read more 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.
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Video Explanation of Leverage Ratio (Debt to Equity)
Top 3 Ratios
These ratios have been curated keeping in mind that banks lend out money that has been borrowed from their depositors and other institutional creditors as well. Therefore, there has to be a threshold on the ratio or portion of the such borrowed sum being borrowed.
Let us understand the top three types of minimum leverage ratios for banks that indicate the creditworthiness, liquidity, financial health and other such important metric to customers, investors, and regulators through the detailed discussion below.
#1 – Tier 1 Leverage Ratio
Tier 1 Leverage Ratio Formula = Tier 1 Capital / Total Assets
This ratio measures the amount of core capital a bank has about its total assets. It was introduced to check a bank’s leverage and reinforce the risk-based requirements through 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%.
According to the Basel III Basel IIIBasel III is a regulatory framework designed to strengthen bank capital requirements while also mitigating risk. It is an extension in the Basel Accords, designed and agreed upon by members of the Basel Committee on Banking Supervision.read more standards, this ratio must be at least 3%, though country-wise regulations may vary.
For example, in Dec 2017, JP Morgan reported a Tier 1 capital of $184,375 million and an asset exposure of $2,116,031 million, resulting in its Tier 1 leverage ratio of 8.7%, well above the minimum requirement.
Source: JPMorgan.com
This measurement metric was introduced in the aftermath of the global financial crisis in 2008 and served as the most important ratio for assessing a bank’s health.
Other commonly used leverage ratios are:-
#2 – Debt-to-Equity Ratio
Debt-to-Equity Ratio Formula = Total Debt / Shareholder’s Equity
This ratio measures a company’s amount of financing from debt versus equity. A debt-to-equity 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 D/E RatioThe debt to equity ratio is a representation of the company's capital structure that determines the proportion of external liabilities to the shareholders' equity. It helps the investors determine the organization's leverage position and risk level. read more is generally undesirable. Banks tend to have a high debt-to-equity because they carry huge amounts of debt on their balance sheet. In addition, they have a significant investment in fixed assets in the form of a branch network.
#3 – Debt-to-Capital Ratio
Debt-to-Capital Ratio Formula = Total Debt / Total Capital (Tier 1 + Tier 2)
Like the debt-to-equity ratio, the debt-to-capital ratio indicates the amount of debt possessed by a bank concerning its total capital. Again, this is usually higher for a bank because of its operations, creating higher exposure to loans. For example, a bank with a debt of $1,000 million and equity of $2,000 million will have a debt-to-capital ratio of 0.33x but a debt-to-equity ratio of 0.5x.
Interpretation
Since we understand the ideal leverage ratios for banks in detail now, it is also equally important to understand how to interpret the data that is generated through the calculations. As in, one must be able to determine if a particular ratio shows healthy signs for the bank or otherwise. Let us do so through the discussion below.
- A higher leverage ratio is generally safer for a bank as it shows that the bank has higher capital than its assets (majorly loans). It is particularly useful when the economy falters, and the loans are not paid off. That is because banks have relatively fewer creditors than debtors, which makes it difficult to write offWrite OffWrite off is the reduction in the value of the assets that were present in the books of accounts of the company on a particular period of time and are recorded as the accounting expense against the payment not received or the losses on the assets.read more the loans, and hence at such times, a high equity capital pays off well.
- A high leverage ratio means the banks have more capital reservesCapital ReservesCapital reserve is a reserve that is formed from the company's profits earned from its non-operating activities during a period of time and is retained for the purpose of financing the company's long-term projects or writing off its capital expenses in the future.read more and are better positioned to withstand a financial crisis. However, it also means less money to loan out, reducing the bank’s profit.
- The Tier 1 leverage ratio is a direct outcome of the crisis, and so far, it has worked well amidst all the amendments. However, investors still rely on banks to calculate this number, which may feed an inaccurate picture.
- Additionally, we would not know the true effect until the next financial crisis, which helps determine whether the banks can withstand a financial crisis.
Frequently Asked Questions (FAQs)
The operating leverage ratio for banks is the comparison of revenue growth with non-interest expense growth. Moreover, a positive balance displays that revenue is increasing more rapidly than expenses. Conversely, the bank accumulates costs faster than revenue if the operating leverage ratio is negative
During leveraging, lenders or banks may utilize this ratio to understand whether the company can pay its dues in due course. Typically, 1.5 to 2 is considered an ideal ratio.
For the bank’s leverage ratio calculation, one must divide the bank’s Tier 1 capital by total consolidated assets to reach the Tier 1 leverage ratio. Next, multiply the result by 100 to convert the number to a percentage.
Usually, the average leverage ratio for banks is 1.5 to 2. Therefore, it is regarded as an ideal ratio.
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