Updated July 21, 2023
Definition of Leverage Ratio for Banks
The leverage ratio for banks is the ratio of the total capital in the banks and their assets. It is a ratio that clearly predicts the financial condition of the banks and also its credit worthiness.
The investors can take advantage of this ratio to decide upon the investment to be made in the banks or not.
The leverage ratio for banks is calculated to know the financial position of the bank the investors can also check the leverage ratio before investing. The leverage ratio is calculated by dividing the Capital by the consolidated assets. This process of finding out the ratio is done to highlight the leverage effect of the bank in terms of its assets. The assets used for the calculations are mainly Tier 1 assets means the assets which can easily be liquidated in a given period of time. Thus this helps to make us understand the worthiness of the bank in case of any financial crisis. The assets that are used in the leverage ratio calculation should be able to be used in the business immediately.
Purpose of Leverage Ratio for Banks
The leverage ratio is generally used by the investors and the regulars of the bank who work on behalf of the bank. The leverage ratio will suggest the investors that in case of the financial crisis the bank will be able to repay all its dues or not because this is a matter of concern for the investors who invest their money. The leverage ratio helps the regulars to limit the capital and they may try to increase their consolidated assets so as to make up for the ratio which is an ideal one for a healthy financial situation. The leverage ratio is the ratio between the Capital and the consolidated assets these consolidated assets are mostly the liquid assets that are easily transformed into cash in case of emergency. Therefore it is very important for the banks to properly do all the leverage related ratio calculation very carefully.
Types of Leverage Ratio for Banks
There are three types of leverage ratio for banks one is Debt ratio another one is debt to equity ratio and the last one is interest coverage ratio.
1. Debt Ratio
The debt ratio is calculated by dividing the total liabilities with the total shareholders’ equity. Therefore it depicts the ratio which says that whether the company is capable enough to cope with the liabilities in comparison with the total shareholders’ equity.
2. Debt to Equity Ratio
The debt to equity ratio is an indication that indicates how much a company can finance from its debt or equity. It is a ratio which is a comparison between the Debt and the equity. The ratio of Debt to equity tells that whether the company is dependent on Debt or equity. If in a bank the Debt to equity ratio is higher than 1 then it is said that the company is taking more debts rather than issuing shares in equity market and if the Debt to equity ratio is less than 1 then it is assumed that the company is generating its finances from the equity more than taking debts.
3. Interest Coverage Ratio
The interest coverage ratio is calculated by dividing the earnings before tax and interest with the interest expenses of the bank. In any bank, interest is one of the main components and thus it is very important to calculate and check the interest coverage ratio before investing. The banks should be able to cover the entire interest cost and thus this ratio plays an important role in this.
Leverage Ratio vs Tier 1 Capital Ratio
- In leverage ratio, the total capital is divided with the total consolidated assets to find out the financial condition of the company whereas the Tier 1 capital ratio is such which is calculated by dividing the equity and capital with the total weighted risk assets.
- The leverage ratio finds out that whether the bank has the potential to deal with the capital in correspondence with its assets whereas the Tier 1 capital ratio portrays the bank’s financial capability in respect of its total risk associated weighted assets.
- In the case of leverage ratio calculation, the consolidated assets are used whereas in the case of the Tier 1 capital ratio the assets with weighted risk are used. The Tier 1 capital ratio is calculated by first categorizing the assets and its weighted risk as per the bank norms suppose there is an asset called cash then its weighted risk is 0% whereas if the asset is a mortgaged one then its weighted risk can be more than 50%. Thus Tier 1 capital ratio is a peculiar type of ratio.
Limitations of Leverage Ratio for Banks
- Leverage ratio is a very helpful tool but sometimes it is very difficult to do the exact calculation
- The leverage ratio requires the total assets and total capital which is sometimes difficult to properly give in figures.
- The investors and the regulators are nowadays very keen to know and understand the Leverage ratio of the banks because these are also one of the important factors which play a vital role.
- The financial situation can sometimes be misleading if the calculation of the ratio is done properly.
- The experts are required to hire and sort this out because the ratio will be one of the deciding factors of the investors.
- In some of the banks, the regulators can introduce some illegal measures to show their Leverage ratio less because they want to show that the assets are higher than the capital but this practice is not always good for the innocent investors.
The leverage ratio for banks is very important to be found out for the investors as well as for the regulators. It is a deciding factor that helps the investors as well as the regulators to decide the investment based on the ratio. The ratio depicts whether the financial condition of the bank is suitable for its assets which are mostly liquid assets to cover up the capital or not. The calculation should be done very carefully because it may affect many who are associated with the bank financially.
This is a guide to Leverage Ratio for Banks. Here we discuss the introduction and types of leverage ratio along with limitations of leverage ratio for banks. You may also look at the following articles to learn more –