What is the Tier 1 Leverage Ratio
The Tier 1 leverage ratio is the relationship between a banking organization's core capital and its total assets. The Tier 1 leverage ratio is calculated by dividing Tier 1 capital by a bank's average total consolidated assets and certain off-balance sheet exposures. Similarly to the Tier 1 capital ratio, the Tier 1 leverage ratio is used as a tool by central monetary authorities to ensure the capital adequacy of banks and to place constraints on the degree to which a financial company can leverage its capital base.
Tier 1 Leverage Ratio
BREAKING DOWN Tier 1 Leverage Ratio
The Tier 1 leverage ratio was introduced by Basel III, an international regulatory banking accord proposed by the Basel Committee on Banking Supervision in 2009. The ratio uses Tier 1 capital to judge how leveraged a bank is in relation to its consolidated assets. The higher the Tier 1 leverage ratio is, the higher the likelihood is of the bank withstanding negative shocks to its balance sheet.
Calculation of Tier 1 Leverage Ratio
The Tier 1 capital, which shows up in the numerator of the leverage ratio, represents a bank's common equity, retained earnings, reserves, and certain instruments with discretionary dividends and no maturity. Tier 1 capital is the core capital of a bank according to Basel III and consists of the most subordinated capital that absorbs losses first during financial stress. Basically, Tier 1 capital is calculated as common equity tier 1 (CET1) capital plus additional Tier 1 capital (AT1).
The denominator in the Tier 1 leverage ratio is a bank's total exposures, which include its consolidated assets, derivative exposure, and certain off-balance sheet exposures. Basel III required banks to include off-balance sheet exposures, such as commitments to provide loans to third parties, standby letters of credit (SLOC), acceptances, and trade letters of credit.
Tier 1 Leverage Ratio Requirements
Basel III established a 3% minimum requirement for the Tier 1 leverage ratio, while it left open the possibility of making the threshold even higher for certain systematically important financial institutions. In 2014, the Federal Reserve, the Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC) released regulatory capital rules that imposed higher leverage ratios for banks of certain sizes effective as of Jan. 1, 2018. Bank holding companies with more than $700 billion in consolidated total assets or more than $10 trillion in assets under management must maintain an additional 2% buffer, making their minimum Tier 1 leverage ratios 5%. In addition, if an insured depository institution is being covered by corrective action framework, meaning it demonstrated capital deficiencies in the past, it must demonstrate at least a 6% Tier 1 leverage ratio to be considered well capitalized.