What are Leverage Ratios for Banks?

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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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.

Top 3 Leverage Ratios Used For Banks

#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.

Key Points to Note

  • 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.

Conclusion

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.

This article is a guide to Leverage Ratios for Banks. We discuss what leverage ratios and 3 major leverage ratios for banks are. Here are the other articles on financial analysis that you may like: –

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