Understanding the Leverage Ratio: Arise, Calculation Methods, and More

What Is Leverage Ratio And How Does it Arise (Process and Source) (Tim, 2009, page 283)

The following Are Components of Leverage Ratio And its Source(s) (Brian, 1999 ). The Following Aspects Influence Leverage Ratio;
What Is Leverage Ratio (LR)? A leverage ratio measures how a company’s indebtedness compares with their assets in an easy and consistent fashion that permits for comparison between entities.

Financial crisis taught us a valuable lesson: financial institutions cannot rely solely on risk taking to generate capital; taking on more risks does not ensure their survival.

There must be an indicator to gauge the quality and capacity for loss-absorbing of capital assets.

How Does Leverage Ratio Arise?

One cause of the global financial crisis has been excessive indebtedness within the financial sector – specifically between loans to clients and capital needs of banks.

Financial institutions receive money from creditors per euro of value they possess, in return for loans granted and deposits accepted as liabilities (debt and deposits). Banks finance assets (loans granted) through capital resources while also incurring debt-service costs on outstanding liabilities such as deposits.

One way of controlling debt would be requiring more capital for financing assets.

  1. Results
    BBVA recorded net earnings of EUR 709 Million during its inaugural Quarter.
  2. Revenues
    Gross margin increased 14.9% year-on-year at constant rates thanks to strong recurring income (interest margin plus commissions). 3. Risks
    At the end of Q1, BBVA saw its NPL ratio decrease from 5.4% in December to 5.3% at quarter end; coverage remains consistent at 74%. Furthermore, fully loaded CET1 ratio reached an all-time high at 10.54% – an improvement by 21 basis points since December!
  3. Transformation By the end of quarter 5, digital customers within BBVA Group had grown by 20% year over year to 15.5 million; of which 9.4 million mobile customers represented an increase of 45% year-on-year.
    However, pre-crisis regulations focused on measuring an entity’s financial health by maintaining a certain percentage of capital based on risk-weighted assets (APRs), taking debt levels into consideration (‘The Flash: What Is Bank Capital And How Can We Calculate It?) (see more here).
    However, during the financial crisis this proved insufficient; therefore banks combined various risk valuation models in order to reach very low APRs.
    Thus, many entities had extremely high capital ratios not because they possessed sufficient funds but due to APRs not reflecting risk in their balance sheets and permitting excessive borrowing with little warning until crisis reached an extreme point.
    These situations force businesses to undertake extremely aggressive deleveraging processes, leading them down a dangerous road of losses, capital decrease, and reduced creditworthiness. How Can Leverage Ratio Be Calculated?

As such, the Basel III Committee considered it appropriate to introduce a measure that complements traditional capital ratios and assesses an entity’s capital quality.

The leverage ratio has since evolved into an efficient calculation that is straightforward, transparent, and comparable across entities. Furthermore, in October 2015 the European Commission adopted this definition based on Basel standards.

The leverage ratio measures the ratio between required Tier 1 (CET1) regulatory capital and total bank assets, including off-balance sheet assets. With this metric in hand, bank controllers aim to achieve two objectives.

On one side, restrict any excessive debt an entity can incur and set aside capital requirements regardless of risk. And secondly, set a measure which reinforces capital requirements regardless of risk – among its many advantages being easy calculation and comparability across risks.
As well as mitigating risk for banks regardless of asset weighting accuracy, balance sheet controls also limit uncontrolled growth in assets on balance sheets and prevent unscheduled asset accumulations.
Combining leverage ratio and risk-weighted capital ratios may prove key in avoiding future financial crises:

Systemic risk can be decreased through this approach by covering all chances facing an entity and restricting autonomy when engaging in high risk activities.
Thus, those organizations with higher risk-weighted assets face constraints in raising capital to meet regulatory requirements while their leverage ratio places limits on those with low APRs. APR stands for Annual Percentile Ratio. interieur 1. Operating Leverage Ratio
Operating leverage ratio is used to evaluate how income fluctuates relative to changes in sales.
Operating Leverage Ratio can be determined using this formula: Operating Leverage Ratio = Percent Change in EBIT (earnings before Interest and Taxes)/Percent Change in Sales Volume.

  1. Net Leverage Ratio
    The ratio of net debt to EBITDA (earnings before interest, taxes, depreciation and amortization) measures how quickly an entity meets its obligation and earnings. It provides insight into how long it would take if debt levels and EBITDA levels remained consistent over time.
    Net Leverage Ratio
    This ratio can be calculated with this equation: Net Leverage Ratio = (Net Debt – Cash Holdings)/ EBITDA. 3. Debt to Equity Ratio
    The debt-equity ratio measures the relationship between total liabilities of a business and stockholder equity.
    Debt to Equity Ratio offers an easily understandable snapshot of a business relative to its debts, calculated using this formula: Debt to Equity Ratio = Liabilities/Shareholder Equity. What Leverage Ratio Do Regulators Require?
    Basel III has set for 2018 a minimum leverage ratio of 3%, meaning capital must cover at least this proportion of assets.

In December 2015, BBVA published its fully loaded leverage ratio incorporating regulatory requirements for 2018 with current data of 6.0%; this was by far the highest among peers.

As of September 2015, the sector average was 4.5%.