The leverage ratio provides a simple measure of bank solvency. Unlike risk-weighted capital requirements, it does not adjust for the riskiness of different assets. Every exposure attracts the same treatment. This simplicity is deliberate. It acts as a check on the more sophisticated risk-weighted framework and catches problems that complex models might miss.
Why a leverage ratio?
Risk-weighted approaches rely on models and assumptions. They assign different capital requirements to different assets based on assessed riskiness. A government bond attracts little or no capital. An unsecured loan attracts more. The system is sophisticated and attempts to be risk-sensitive. But it is vulnerable to error. What if the risk weights are wrong?
The financial crisis exposed problems with this approach. Some risk weights proved badly miscalibrated. Assets rated as safe turned out to be anything but. AAA-rated mortgage securities suffered severe losses. Banks held thin capital against large exposures because the models said they were low risk. When those assets lost value, the losses overwhelmed the capital that had seemed adequate. The sophisticated approach failed precisely when it mattered most.
The leverage ratio acts as a backstop. Even if risk weights are wrong, even if models fail, the leverage ratio ensures a minimum capital backing for every pound of exposure. It catches what risk-based requirements miss. It provides a floor that does not depend on getting risk assessment right. If the models are correct, the leverage ratio should not bind. If it does bind, something may be wrong with the risk assessment.
How it works
The leverage ratio divides Tier 1 capital by total leverage exposure. Tier 1 capital is the high-quality capital that can absorb losses while the bank remains a going concern. Total leverage exposure includes balance sheet assets, derivative exposures using the standardised approach for counterparty credit risk, securities financing transactions such as repos, and off-balance sheet commitments. Credit conversion factors reduce off-balance sheet items to account for the probability they become on-balance sheet exposures.
The minimum requirement under Basel III is 3%. A bank with £100 billion of leverage exposure must hold at least £3 billion of Tier 1 capital. This applies regardless of how safe those exposures appear under risk-weighted measures. A portfolio of government bonds attracts the same leverage exposure as a portfolio of risky loans. Every asset counts the same.
Systemically important banks face additional requirements. Global systemically important banks must hold a leverage ratio buffer equal to half their risk-weighted GSIB buffer. This results in effective requirements above the 3% minimum. The largest banks must maintain higher leverage ratios reflecting the systemic risk they pose to the financial system.
UK requirements
The UK leverage ratio framework requires a minimum of 3.25% for larger firms. This applies to banks with more than £50 billion of retail deposits or £10 billion of non-UK assets. Additional buffers apply for systemically important firms including a countercyclical leverage ratio buffer that moves with the countercyclical capital buffer.
The PRA is currently reviewing the thresholds that determine which firms fall within the leverage ratio framework. A modification by consent is available for firms that only recently crossed the thresholds while this review completes. Growing firms that have just become subject to the requirement may get temporary relief while arrangements are put in place.
EU requirements
The EU implements the 3% minimum through CRR. Additional requirements apply to global systemically important institutions. The framework aligns with Basel standards. There is no higher base requirement as in the UK though GSIB buffers apply to the largest institutions.
Criticism and defence
Some argue the leverage ratio penalises low-risk activities. A bank holding government bonds or providing client clearing services faces the same leverage exposure as one holding risky loans. This may discourage beneficial activities that support market functioning and economic stability. Banks may pull back from services that do not generate enough return to cover the leverage ratio cost.
Proponents counter that this is precisely the point. The risk-weighted framework already rewards low-risk activities with lower capital charges. The leverage ratio prevents banks from accumulating vast exposures to supposedly safe assets that may prove riskier than expected. If those activities really are safe, the risk-weighted measure should be the binding constraint and the leverage ratio should not bite.
The leverage ratio is not meant to be the primary constraint for well-run banks. For most banks in normal times, risk-weighted requirements should bind more tightly. The leverage ratio should act as a backstop that only binds when something has gone wrong with risk measurement. If a bank finds the leverage ratio binding, it should ask why its risk-weighted requirements are so low relative to its total exposures.
