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1 1 (December 9, 2015)

handle is hein.crs/govccvp0001 and id is 1 raw text is: FF. ' ,iE ,E .$r. i , p\w -- , gnom go mppm qq\ , q I aS 11LIANJILiN, Updated December 9, 2015 Leverage Ratios in Bank Capital Requirements This In Focus provides a summary of leverage ratios used in bank capital requirements. It also explains the concept of leverage and the rationale behind a leverage ratio. L , eragcei ,,und dhe I Ck s.s What Is Leverage? A firm or individual can use debt (borrow) or their own funds (capital) to purchase assets. Generally, leverage is the use of debt, and increasing the use of debt relative to capital is referred to as becoming more leveraged. Why Are Banks Leveraged? In the simplest form of banking, a bank takes in deposits and uses them to make loans. This is leveraged finance because the bank is using debt (deposits) to acquire assets (loans). Banks can also use capital to fund loans, but if the rate of return paid on capital is higher than the rate paid to depositors, it would be less costly for a bank to finance its activities with deposits. Why Was Leverage an Issue in the Financial Crisis? A financial firm may use leverage to reduce its funding costs. But if assets fall in value, financial firms need capital to absorb those losses. Greater leverage means firms have less capital relative to assets, and therefore have relatively less ability to absorb losses before failing. Many economists view excessive leverage as a contributing factor to the severity of the crisis. Leveraged losses depleted capital, causing investors to fear that firms might fail, making them unwilling to provide firms with more debt or capital. Firms were forced to sell assets thereby further depressing the prices of assets-or reduce lending in order to reduce leverage (deleverage). Deleveraging reduced the availability of credit for businesses and households, thereby increasing the severity of the recession. What Role Did Off-Balance Sheet Exposures Play in the Crisis? Some financial firms used off-balance sheet activities such as credit derivatives in which the bank is selling protection and credit guarantees. These increased risk exposures in ways that investors could not easily detect beforehand and, in some cases, allowed firms to become more leveraged. Subsequent losses caused by off-balance sheet exposures contributed to an atmosphere of uncertainty and unwillingness to lend or invest that spiraled into financial instability. What Is Basel III? In response to the crisis, 27 countries agreed in 2010 to modify the Basel Accords, shared bank regulatory standards. The agreement, known as Basel III, included modifications to capital requirements, which U.S. bank regulators implemented through rulemaking in 2013. For more information, see CRS Report R42744, U.S. Implementation of the Basel Capital Regulatory Framework, by Darryl E. Getter. What Are Bank Capital Requirements? As part of U.S. safety and soundness regulation, banks are required to maintain various capital-to-asset ratios, one of which is the leverage ratio. If banks fail to meet these ratios, regulators must take prompt corrective action. How Is Leverage Defined in Capital Requirements? The leverage ratio has a specific meaning in capital requirements. It is the ratio of Tier 1 capital (with certain adjustments) to consolidated assets. Tier 1 capital is high- quality, loss-absorbing forms of capital, such as common equity. (Basel III tightened the definition of Tier 1 capital.) Unlike other regulatory capital ratios, assets are not risk- weighted for purposes of the leverage ratio. How Did Basel III Change the Leverage Ratio? The rule implementing Basel III raised the minimum leverage ratio from 3% to 4% for certain banks, including those with a strong supervisory rating. (Banks that did not have a strong supervisory rating were already required to maintain a 4% leverage ratio.) In other words, the value of the bank's Tier 1 capital must be equal to at least 4% of the value of the bank's assets. The bank must maintain a leverage ratio of at least 5% to be considered well capitalized, however. Why Have Both a Leverage Ratio and Risk-Weighted Capital Ratios? Basel III measures most capital ratios in terms of risk-weighted assets to account for the fact that some assets are riskier than others. To determine how much capital is needed, each asset is assigned a risk weight; assets with higher risk weights require more capital. For example, if an asset received a 50% risk weight, half of its value would be included in the denominator of a capital ratio. A basic tenet of finance is that riskier assets have a higher expected rate of return in order to compensate the investor for bearing more risk. Without risk weighting, banks would have an incentive to hold riskier assets since the same amount of capital must be held against riskier and safer assets. But risk weights may prove inaccurate. For example, banks held highly rated mortgage-backed securities (MBSs) before the crisis, in part because those assets had a higher expected rate of return than other assets with the same risk weight. MBSs then suffered unexpectedly large losses during the crisis. Thus, the leverage ratio can be thought of as a backstop to ensure that incentives posed by risk- weighted capital ratios to minimize capital and maximize risk within a risk weight do not result in a bank holding insufficient capital. The leverage ratio is simpler and more transparent than risk-weighted capital measures because the public does not K~:>

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