Leverage ratio

Topic: Banking Regulation, NPAs and Financial Stability · NCERT: Beyond NCERT

Meaning

The leverage ratio is a bank's Tier 1 capital (its best-quality own money) divided by its total exposure (all its assets and off-balance-sheet commitments), with no risk weights:

Leverage ratio = Tier 1 capital ÷ Total exposure (on-balance-sheet + off-balance-sheet) × 100

It came with Basel III (2010) as a simple backstop to risk-based capital rules. It still works when banks make their assets look safer than they are. It also puts a hard limit on how much a bank can borrow to build its balance sheet.

Explanation

How it works

• Leverage means buying assets with borrowed money. For a bank, the borrowed money is mostly deposits.
• Leverage makes profits bigger in good times.

• It also makes losses bigger in bad times.

• Less capital means more leverage. A smaller loss can then wipe out the owners' money and make the bank insolvent (it owes more than it owns).

• The leverage ratio sets a minimum amount of Tier 1 capital for every rupee of exposure, however "safe" the assets are said to be.
• Numerator: Tier 1 capital only. This is "going-concern" capital, meaning it absorbs losses while the bank keeps running. It has two parts:
• CET1 (Common Equity Tier 1): common shares, share premium, retained earnings and disclosed reserves.
• AT1 (Additional Tier 1): perpetual, non-cumulative instruments that are written down or converted into equity when the bank is in trouble.

• Tier 2 is left out. Tier 2 includes subordinated debt and general provisions, and it absorbs losses mainly when the bank is wound up.

• Denominator: total exposure. It has two parts:

• On-balance-sheet items: loans, bonds and other assets.
• Off-balance-sheet items: promises that are not yet assets but can become loans later, such as guarantees and credit lines.
• Every item counts at its full value. A G-sec (government security) counts the same as a corporate loan.

Why a "no risk weight" ratio was needed

• Basel II allowed banks to use their own models to set risk weights (the internal ratings-based approach).
• In the 2008 crisis:
• Banks' models showed low risk weights.
• So banks held too little capital.

• Their risk-based ratios looked healthy, but they were too highly leveraged.

• The leverage ratio fixes this. Because it ignores risk weights, a bank cannot improve it by gaming risk weights (showing assets as safer than they are).

• Basel III final reforms (2017, "Basel IV") added the output floor for the same reason: RWA from a bank's own models cannot fall below a set share of RWA under the standardised approach.

Worked example

• A bank has Tier 1 capital = Rs 40 and total exposure = Rs 1,000.
• Leverage ratio = 40 ÷ 1,000 = 4%.

• This just meets the 4% minimum for D-SIBs and is above the 3.5% needed by other banks in India.

• What 4% means: the bank can have at most Rs 25 of exposure for every Rs 1 of Tier 1 capital (1 ÷ 0.04 = 25).

• Why gaming risk weights does not help:
• Say the bank's own models cut its risk-weighted assets (RWA) from Rs 440 to Rs 300.
• Its risk-based ratio goes up (40 ÷ 440 ≈ 9.1% becomes 40 ÷ 300 ≈ 13.3%).
• Its leverage ratio stays at 4%, because total exposure is still Rs 1,000.

What makes it rise or fall

• It rises when:
• the bank raises new equity or keeps profits as retained earnings
• the government puts in new capital (recapitalisation of PSBs)

• the bank shrinks its loans or off-balance-sheet commitments

• It falls when:

• losses (for example from bad loans or NPAs) reduce CET1
• the bank pays large dividends
• the balance sheet grows fast while capital stays the same, as in a credit boom

In India

• Regulator: the RBI turns Basel norms into Indian rules. The Basel norms set by the BCBS (Basel Committee on Banking Supervision, housed at the BIS, Basel) are not legally binding. India has been a BCBS member since 2009.
• Basel III capital regulations took effect in India from 1 April 2013, and banks must meet the minimums on an ongoing basis. [1] The full phase-in was completed in October 2021.
• India's leverage ratio minimums are stricter than Basel's:

Bank type	Basel III	India (RBI)
D-SIBs (Domestic Systemically Important Banks, the "too big to fail" banks)	3%	4%
Other banks	3%	3.5%

• Why India sets stricter levels:
• PSBs have a history of high NPAs.
• Loans are often concentrated in a few sectors or companies.

• The stricter levels give an extra safety margin.

• Capital position: SCBs' CET1 rose from 9.98% (March 2015) to 14.81% (March 2025), and their CRAR rose from 12.94% to 17.36%. [3] CET1 is the core of Tier 1, which is the numerator of the leverage ratio.

• Stress tests in the RBI's Financial Stability Report (June 2026) show that SCBs' capital stays above the regulatory minimum even in adverse scenarios. [2]

Don't confuse with

• CRAR / Capital Adequacy Ratio: this is (Tier 1 + Tier 2) ÷ risk-weighted assets, with a minimum of 9% in India. The leverage ratio uses Tier 1 only, divides by total exposure, and has no risk weights.
• Tier 1 capital ratio: this is Tier 1 ÷ RWA, with a minimum of 7% in India. [1] It has the same numerator as the leverage ratio but a risk-weighted denominator.
• Capital conservation buffer (CCB): this is 2.5% of RWA, held in CET1. Breaching it limits dividends. It is a risk-based buffer, not a leverage cap.
• Output floor (Basel III final reforms, 2017): this also limits model gaming, but it works inside the risk-weighted system by putting a floor under model-based RWA. The leverage ratio works outside that system.

Prelims Hooks

• Leverage ratio = Tier 1 capital ÷ total exposure (on- and off-balance-sheet items). No risk weights are used, and Tier 2 is not counted.
• Minimums: Basel III 3%. India 4% for D-SIBs and 3.5% for other banks.
• It was introduced by Basel III (2010), not by Basel I or Basel II. Its purpose is to act as a backstop against gaming risk weights.
• Trap: capital ÷ total assets (for example 50 ÷ 1,000 = 5%) is close to the leverage ratio. Capital ÷ RWA (50 ÷ 440 ≈ 11.4%) is the CRAR. Do not mix up the two.
• Trap: AT1 bonds count in Tier 1, so they count in the leverage ratio. General provisions are Tier 2, so they do not.
• Basel III capital rules have applied in India from 1 April 2013. [1]

Mains Points

• Risk-sensitive rules vs simple rules:
• Risk weights reward safer lending, but banks can game them. That happened before 2008, when banks' own models showed low risk and banks held too little capital.
• The leverage ratio is simple and hard to game, but it treats a G-sec and a risky loan the same way.

• So the leverage ratio works best as a backstop, not as the only rule. A good answer argues that safety needs CRAR, the leverage ratio, the output floor, liquidity rules (LCR/NSFR), supervision (Pillar 2) and disclosure (Pillar 3) together.

• Safety vs credit growth:

• India's stricter limits (4% for D-SIBs, 3.5% for others, against 3% under Basel) protect depositors in a system with a history of NPAs.
• But more capital per rupee of exposure makes lending costlier. Capital-short PSBs may cut loans, as happened under Prompt Corrective Action in 2017-18, when credit to MSMEs was squeezed.

• A good answer weighs the fiscal cost of recapitalisation against the growth cost of tight credit.

• Capital + resolution = stability:

• Strong Tier 1 capital (CET1 14.81%, March 2025) [3] gives banks room to absorb losses.
• NPA recognition (AQR 2015) and resolution (IBC 2016) remove bad assets.
• Neither works alone. A leverage cap limits how big losses can grow, and resolution clears them.

Related concepts

• Leverage
• Basel norms
• Basel I
• Basel II
• Three pillars of Basel
• Capital adequacy ratio
• Risk-weighted assets
• Tier 1 capital
• Common Equity Tier 1
• Additional Tier 1 capital

Read more

• Capital adequacy: Basel I to Basel III