How to Calculate the Leverage Ratio for Bank Management

Leverage ratios are key in determining a bank's health.
Leverage ratios are key in determining a bank's health. (Image: Hemera Technologies/ Images)

Calculate the leverage ratio by dividing a bank's equity by its assets. The Federal Deposit Insurance Corporation established acceptable ratios, as well as definitions of assets and equity, as a means to limit the risk a bank can take on. The idea is to make sure a bank has enough equity, also called capital, to comfort any economic fall, particularly in light of the many risky bank products on the market.

Examine a bank's equity. The FDIC refer to the numerator in this equation as "tier 1 capital." It equals equity plus reserves minus intangible assets such as goodwill and money held aside to pay for taxes. Equity includes items such as common stock, which can be quickly liquidated. Reserves are in the same category since they include cash readily in hand. This information is found in the bank's balance sheets.

Examine a bank's total assets. This information also is available on a bank's balance sheets. Assets for a bank include the book of loans, the earnings from servicing those loans and income from non-bank items such as investing or insurance services. Riskier non-banking products such as derivatives are listed as assets, as well. Credit-default swaps, which are derivative products, were seen as the major factor in the financial crisis beginning in 2007. The FDIC included these as assets to improve a bank's chances of remaining open by making sure there was capital to cushion the risk.

Compare the leverage ratio with federal guidelines. U.S. banks are subject to leverage ratios based on findings of the Bank of International Settlements. In an accord developed by the BIS known as Basal II, regulations were created that say strong U.S banks should have a ratio of 3 percent or above. The Federal Reserve defines a strong bank based on a five-point rating system that looks at reserves, earnings and other items. All other banks should have a ratio of 4 percent. Therefore, a strong bank with $500 million in assets should have a capital, or equity, ratio of at least $15 million, which is 3 percent of its assets. All other banks with the same asset level should have a ratio of at least $20 million, which is 4 percent.

Increase the capital component. A bank or bank holding company with a ratio that is too low has a couple of options. A publicly traded bank can issue more stock to increase its capital position, assuming there are individuals willing to buy the stock. Smaller banks that aren't publicly traded often depend on investors to increase their positions. The other option is to sell bank assets, though this is not the most attractive choice since this leads to a weaker balance sheet and thus a weaker bank.

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