The Tier 1 leverage ratio measures a bank’s core capital relative to its total assets. This crucial metric evaluates how leveraged a bank is, focusing specifically on Tier 1 capital. Tier 1 capital includes assets that are easily liquidated, ensuring a bank’s resilience during financial crises. This ratio is pivotal in assessing a bank’s near-term financial health.
Regulators frequently use the Tier 1 leverage ratio to ensure the capital adequacy of banks and impose limitations on financial companies’ leverage based on their capital base.
Key Takeaways
- The Tier 1 leverage ratio compares a bank’s Tier 1 capital to its total assets to determine leverage.
- Bank regulators employ this ratio to ensure banks maintain sufficient liquidity to pass necessary stress tests.
- A ratio above 5% typically indicates strong financial health for a bank.
Formula for the Tier 1 Leverage Ratio
Tier 1 Leverage Ratio = (Tier 1 Capital / Consolidated Assets) × 100
Where:
- Tier 1 Capital includes common equity, retained earnings, reserves, and certain other instruments.
How to Calculate the Tier 1 Leverage Ratio
- Determine Tier 1 Capital: This includes the bank’s common equity, retained earnings, reserves, and select instruments with discretionary dividends and no maturity.
- Consolidated Assets: Gather the bank’s total consolidated assets for the period, typically found in quarterly or annual earning reports.
- Compute the Ratio: Divide Tier 1 capital by total consolidated assets and multiply by 100 to get the percentage.
What the Tier 1 Leverage Ratio Reveals
The Tier 1 leverage ratio was established by the Basel III accords, an international banking regulatory treaty. This ratio indicates how leveraged a bank is concerning its overall assets. A higher Tier 1 leverage ratio signifies greater capability of the bank to withstand balance sheet shocks.
Components of the Tier 1 Leverage Ratio
- Tier 1 Capital: Core capital including stable, liquid forms able to absorb losses during financial stress.
- Total Exposures: Encompasses consolidated assets, derivative exposure, and certain off-balance sheet exposures.
Tier 1 Leverage Ratio Requirements
Basel III mandates a minimum 3% Tier 1 leverage ratio, with higher thresholds possible for significantly important institutions. In the U.S., regulatory bodies like the Federal Reserve, OCC, and FDIC require banks above certain asset thresholds to maintain higher minimum ratios.
For example, bank holding companies managing over $700 billion in consolidated total assets or $10 trillion in assets require at least a 5% Tier 1 leverage ratio.
Real-World Example of the Tier 1 Leverage Ratio
Let’s say Bank ABC reports its Q3 earnings:
- Highlights a Tier 1 leverage ratio of 8.3%.
- Total Tier 1 capital: $186.189 billion
- Total assets: $2.240 trillion
- The ratio computation: $(186.189 / 2.240) imes 100 = 8.3%$
Bank ABC’s 8.3% ratio showcases its strong position above the standard 5% regulatory requirement.
Differences Between the Tier 1 Leverage Ratio and Tier 1 Capital Ratio
- Tier 1 Capital Ratio: Focuses on a bank’s core equity capital to its risk-weighted assets, reflecting credit risk inclusions.
- Tier 1 Leverage Ratio: Looks at core capital in relation to total assets, providing a broader levered overview.
Limitations of the Tier 1 Leverage Ratio
While important, this ratio is subject to the accuracy of banks’ reported capital and asset figures. Misreporting can lead to flawed leverage ratios, but regulators use a 5% benchmark to differentiate potentially strong economies from vulnerable ones.
What Tier 1 Leverage Ratios of Major Banks Look Like
As of Q1 2023, notable Tier 1 leverage ratios include:
- Citibank: 8.82%
- JPMorgan Chase: 8.60%
- Wells Fargo: 8.55%
- Bank of America: 7.88%
Minimum Tier 1 Capital Ratio for Banks
According to the Basel Accords, banks must uphold at least an 8% capital ratio—6% Tier 1 capital, inclusive of 4.5% Common Equity Tier 1 (CET1).
Understanding CET1 and the Tier 1 Leverage Ratio
Common Equity Tier 1 (CET1) is a crucial element of Tier 1 capital and represents a more liquid subset paired with easy-to-sell assets. CET1, along with additional Tier 1 capital (AT1), represents the total Tier 1 capital.
Conclusion
- The Tier 1 leverage ratio gauges a banking organization’s financial robustness by dividing core capital against average total consolidated assets. Maintaining a ratio above 5% ensures that a bank is adequately capitalized and resilient enough to meet financial obligations.
Related Terms: Tier 1 capital, Basel III, financial health, leverage ratio, bank regulation
References
- Bank for International Settlements. “Basel III: Finalising Post-Crisis Reforms”, Page 9.
- Bank for International Settlements. “Basel III: Finalising Post-Crisis Reforms”, Page 25.
- Bank for International Settlements. “Basel III: Finalising Post-Crisis Reforms”, Page 140.
- Federal Register. “Regulatory Capital Rules: Regulatory Capital, Revisions to the Supplementary Leverage Ratio”.
- BankRegData. “All U.S. Banks. Tier 1 Leverage Ratio”.
- Bank for International Settlements. “Definition of Capital in Basel III – Executive Summary”.
