Leverage ratio (LR) is defined by the ratio between Tier-1 capital and total exposure (off and on balance-sheet exposure), which does not consider credit-worthiness.

It is said that:

[loans to] businesses with good underlying credit risk are more likely to be LR-consuming (this means that the implicit capital requirement under the LR formula is higher than the usual capital requirement). LR-consuming business may eventually cause the bank to be LR constrained (close to breaching the condition, unless exposure is reduced or capital increased)

I fail to understand above statement. Why good credit-risk business is LR consuming and implicit capital requirement under the LR formula is higher?

Why and how LR-consuming business may eventually cause the bank to be LR constrained?

Could you please explain above statements in simpler language?


1 Answer 1


Traditional bank capital requirements were "risk based". A loan to a low-rated (high risk) firm required more capital than a loan to a high-rated (low credit risk) firm. This is how Basel I and II worked. This made sense at the time since a low-rated loan is more likely to default than a high rated loan.

However, in 2007 and 2008, plenty of banks got in trouble buying AAA rated securities. This could happen in several ways: the credit rating agencies might assign AAA rating to securities that do not deserve it (LOL, no one is perfect), or the risks involved might not credit risks (long term US government bonds have no credit risk but they have plenty of interest rate risk). The regulators were not happy, their regulations had not worked. Many of them thought relying on credit rating agencies had been a mistake.

To remedy this situation Basel III introduced an additional requirement, the LR or Leverage Ratio in addition (not as a replacement of the old rule). This ratio does not look at credit risk at all but simply at the total leverage of the Bank. For some Banks the LR does not matter (they satisfy the requirement easily) but for others the LR becomes binding or relevant to them. As you leverage more and more at some point you run out of room or you hit the ceiling created by the new LR rule.

Which Banks are more affected by the LR? Well, the whole purpose was to prevent too much buying of AAA right? Not surprising the Banks more likely to be affected are those that have large portfolio of low credit risk securities (high grade mortgage securities for example). That is almost a tautology right? The LR is just doing its job. By not showing any leniency towards high rated securities (like credit risk regs do) the new rules necessarily penalize Banks who buy such securities.

"LR-consuming activities" are simply Bank activities that increase the likelihood that the LR limit will be reached.


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