What is Leverage Ratios for Banks?
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 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. 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.
Top 3 Leverage Ratios Used For Banks
#1 – Tier 1 Leverage Ratio
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
#2 – Debt to Equity Ratio
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 ratioD/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. 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
#3 – Debt to Capital Ratio
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
Key Points to Note
- A higher leverage ratio is generally considered safer for a bank as it shows that the bank has higher capital compared to its assets (majorly loans). This is particularly useful when the economy falters, and the loans are not paid off. Banks have relatively fewer creditors than it has 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. 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. and are better positioned to withstand a financial crisis. However, it also means that it has less money to loan out, thereby 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 are still reliant on banks to calculate this number, and it is highly possible that investors will be fed an inaccurate picture.
- Additionally, we won’t know the true effect of this ratio until the next financial crisis that helps us find out whether the banks are truly able to withstand a financial crisis.
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 –