Leverage Ratio (Banking)
The Banking Leverage Ratio is a non-risk-based capital adequacy measure that divides Tier 1 capital by total leverage exposure (a comprehensive measure of on- and off-balance-sheet assets), preventing banks from becoming excessively leveraged even if risk-weighted asset calculations show low capital requirements.
Risk-weighted capital ratios like the CET1 ratio have an inherent limitation: they depend on the accuracy of risk weights assigned to each asset. If risk models underestimate the true risk of certain exposures — as occurred with highly rated mortgage-backed securities before 2008 — a bank can appear well-capitalized on a risk-adjusted basis while being dangerously leveraged in absolute terms. The leverage ratio addresses this by treating all assets (largely) equally, regardless of their assigned risk weight.
Under Basel III as implemented in the US, the minimum supplementary leverage ratio (SLR) for advanced approaches bank holding companies is 3% at the consolidated holding company level, with enhanced SLR (eSLR) requirements of 5% at the holding company and 6% at the insured depository subsidiary for the eight US G-SIBs (JPMorgan Chase, Bank of America, Goldman Sachs, Morgan Stanley, Citigroup, Wells Fargo, Bank of New York Mellon, State Street). Breaching the eSLR buffer triggers restrictions on capital distributions.
The leverage exposure denominator differs from simple total assets. It includes on-balance-sheet assets, derivatives exposures (measured as replacement cost plus potential future exposure), securities financing transaction exposures, and certain off-balance-sheet commitments. This comprehensive measure prevents gaming through off-balance-sheet structures.
US banks hold vast quantities of US Treasuries and reserve deposits at the Federal Reserve — both very low-risk assets but counted equally in the leverage ratio denominator. During the COVID-19 pandemic in 2020, the Federal Reserve temporarily excluded Treasuries and Fed deposits from the SLR denominator to encourage banks to expand balance sheets and provide market liquidity. When this relief expired in March 2021, some analysts attributed subsequent Treasury market volatility partly to banks managing their leverage ratio exposure.
For investors, the leverage ratio can be a binding constraint on balance sheet expansion and return on equity at the largest banks, making it an important input when modeling capital return capacity and loan growth.