Tier 1 Leverage Ratio

What Is the Tier 1 Leverage Ratio?

The Tier 1 leverage ratio measures a bank's core capital relative to its total assets. The ratio looks specifically at Tier 1 capital to judge how leveraged a bank is based on its assets. Tier 1 capital are those assets that can be easily liquidated if a bank needs capital in the event of a financial crisis. The Tier 1 leverage ratio is thus a measure of a bank's near-term financial health.

The Tier 1 leverage ratio is frequently used by regulators to ensure the capital adequacy of banks and to place constraints on the degree to which a financial company can leverage its capital base.

The Formula for the Tier 1 Leverage Ratio Is:

Tier 1 Leverage Ratio = Tier 1 Capital Consolidated Assets × 1 0 0 where: Tier 1 Capital = Common equity, retained earnings, reserves, plus certain other instruments \begin{aligned} &\text{Tier 1 Leverage Ratio} = \frac{ \text{Tier 1 Capital} }{ \text{Consolidated Assets} } \times 100 \\ &\textbf{where:} \\ &\text{Tier 1 Capital} = \text{Common equity, retained earnings,} \\ &\text{reserves, plus certain other instruments} \\ \end{aligned} Tier 1 Leverage Ratio=Consolidated AssetsTier 1 Capital×100where:Tier 1 Capital=Common equity, retained earnings,reserves, plus certain other instruments

How to Calculate Tier 1 Leverage Ratio

1. Tier 1 capital for the bank is placed in the numerator of the leverage ratio. Tier 1 capital represents a bank's common equity, retained earnings, reserves, and certain instruments with discretionary dividends and no maturity.
2. The bank's total consolidated assets for the period is placed in the denominator of the formula, which is typically reported on a bank's quarterly or annual earnings report.
3. Divide the bank's Tier 1 capital by total consolidated assets to arrive at the Tier 1 leverage ratio. Multiply the result by 100 to convert the number to a percentage.

What Does the Tier 1 Leverage Ratio Tell You?

The Tier 1 leverage ratio was introduced by the Basel III accords, an international regulatory banking treaty proposed by the Basel Committee on Banking Supervision in 2009. The ratio uses Tier 1 capital to evaluate how leveraged a bank is in relation to its overall assets. The higher the Tier 1 leverage ratio is, the higher the likelihood that the bank could withstand a negative shock to its balance sheet.

Components of the Tier 1 Leverage Ratio

Tier 1 capital is the core capital of a bank according to Basel III and consists of the most stable and liquid capital as well as the most effective at absorbing losses during a financial crisis or downturn.

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 increasing that threshold 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 a 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.

Real-World Example of the Tier 1 Leverage Ratio

Below are the capital ratios taken from the financial statements of Bank of America Corporation (BAC) as reported in the bank's Q3 earnings report on October 31, 2018.

Image by Sabrina Jiang © Investopedia 2020

The Difference Between the Tier 1 Leverage Ratio and the Tier 1 Capital Ratio

The Tier 1 capital ratio is the ratio of a bank’s core Tier 1 capital — that is, its equity capital and disclosed reserves — to its total risk-weighted assets. It is a key measure of a bank's financial strength that has been adopted as part of the Basel III Accord on bank regulation.

The Tier 1 capital ratio measures a bank’s core equity capital against its total risk-weighted assets, which include all the assets the bank holds that are systematically weighted for credit risk. The Tier 1 leverage ratio measures a bank's core capital to its total assets. The ratio uses Tier 1 capital to judge how leveraged a bank is in relation to its consolidated assets, whereas the Tier 1 capital ratio measures the bank's core capital against its risk-weighted assets.

Limitations of Using the Tier 1 Leverage Ratio

A limitation of using the Tier 1 leverage ratio is that investors are reliant on banks to properly and honestly calculate and report their Tier 1 capital and total assets figures. If a bank doesn't report or calculate their figures properly, the leverage ratio could be inaccurate. A leverage ratio above 5% is currently what regulators are looking for, but we won't actually know until the next financial crisis hits to find out whether banks are truly able to withstand a financial shock that it causes.