Adjusted average leverage ratio

What Is Adjusted Average Leverage Ratio?

The Adjusted Average Leverage Ratio is a critical metric in regulatory finance, specifically within the banking sector. It represents a bank's Tier 1 capital relative to its total leverage exposure, calculated as an average over a specified period, and often includes specific adjustments to account for various on- and off-balance sheet exposures. This ratio serves as a backstop to traditional risk-weighted assets ratios, aiming to prevent the buildup of excessive leverage within the financial system by imposing a simpler, non-risk-based capital requirement. The "adjusted" aspect implies modifications to the standard leverage ratio calculation, often driven by specific regulatory objectives or a more comprehensive capture of a bank's true exposure to potential losses. This focus on a broader measure of exposure helps ensure the financial stability of individual financial institutions and the broader market.

History and Origin

The concept of a leverage ratio as a regulatory tool gained significant prominence in the aftermath of the 2008 global financial crisis. Prior to this, bank capital requirements were primarily based on risk-weighted assets, which some critics argued did not adequately capture all forms of leverage or risks. The crisis revealed that banks could appear well-capitalized under risk-based measures while still holding substantial off-balance sheet exposures and other forms of hidden leverage.³⁰, ³¹

In response, the Basel Committee on Banking Supervision (BCBS) introduced a new, non-risk-based leverage ratio as part of the Basel III framework. This framework was published in 2010, with the leverage ratio component formally outlined in January 2014, following a consultative process in June 2013.²⁸, ²⁹ The aim was to complement the risk-based capital framework by ensuring broad capture of both on- and off-balance sheet sources of banks' leverage and to restrict the build-up of excessive leverage.²⁷ The Basel III leverage ratio was defined as Tier 1 capital divided by an exposure measure, expressed as a percentage, with a minimum requirement of 3%.²⁵, ²⁶ Subsequent domestic regulations, such as those by the Office of the Comptroller of the Currency (OCC), Federal Reserve System, and Federal Deposit Insurance Corporation (FDIC) in the United States, further refined and implemented these standards, including specific adjustments and requirements for global systemically important banks (G-SIBs).²⁴

Key Takeaways

• The Adjusted Average Leverage Ratio is a regulatory measure that assesses a bank's financial soundness by comparing its Tier 1 capital to its total adjusted exposures, often calculated as an average over a period.
• It serves as a non-risk-based backstop to traditional risk-weighted capital ratios, aiming to capture leverage not fully addressed by risk-based frameworks.
• Adjustments often include factoring in off-balance sheet exposures, derivatives, and securities financing transactions for a more comprehensive view of a bank's overall leverage.
• This ratio is crucial for supervisors in monitoring systemic risk and promoting financial stability within the banking sector.
• Regulatory bodies like the Basel Committee and national regulators frequently review and modify the definition and calibration of such ratios.

Formula and Calculation

The specific formula for an Adjusted Average Leverage Ratio can vary based on regulatory frameworks and the exact nature of the adjustments. However, it generally follows the core structure of a leverage ratio:

$\text{Adjusted Average Leverage Ratio} = \frac{\text{Average Tier 1 Capital}}{\text{Average Total Adjusted Exposure Measure}}$

Where:

• Average Tier 1 Capital: This is the average of a bank's Tier 1 capital over a specified period (e.g., three months, a quarter). Tier 1 capital represents the highest quality of a bank's capital, primarily consisting of common equity and disclosed reserves, which are capable of absorbing losses.²², ²³
• Average Total Adjusted Exposure Measure: This is the average of a bank's total exposures, incorporating specific adjustments, over the same period. The total exposure measure typically includes:
  • On-balance sheet exposures: These are generally based on accounting values, net of specific provisions.²¹
  • Derivative exposures: Calculated to include both replacement cost and potential future exposure. Eligible bilateral netting agreements may reduce the exposure amount, but collateral usually does not.¹⁹, ²⁰
  • Securities financing transaction (SFT) exposures: Such as repurchase agreements (repos).¹⁸
  • Off-balance sheet items: These are converted to on-balance sheet equivalents using credit conversion factors, with a floor applied.¹⁶, ¹⁷

The "adjusted" aspect often refers to specific nuances in how these exposure categories are defined or particular items are included or excluded based on regulatory intent. For instance, temporary adjustments were made to the Supplementary Leverage Ratio in the U.S. during the COVID-19 pandemic to exclude U.S. Treasuries and deposits at Federal Reserve Banks from the denominator.¹⁵

Interpreting the Adjusted Average Leverage Ratio

Interpreting the Adjusted Average Leverage Ratio involves understanding its purpose as a broad, non-risk-sensitive measure of financial soundness. A higher Adjusted Average Leverage Ratio generally indicates a stronger capital position relative to a bank's total adjusted exposures. This implies that the bank has a larger buffer of equity and other high-quality capital to absorb potential losses, regardless of the perceived credit risk of its underlying assets.

Regulators use this ratio to ensure that banks do not accumulate excessive leverage even if their risk-weighted assets appear low. It acts as a floor, preventing banks from becoming overly reliant on debt financing simply because their assets are assigned low-risk weights. A ratio that falls below regulatory minimums signals potential financial distress and can trigger supervisory intervention. Conversely, a significantly high ratio might suggest a very conservative approach to capital management, potentially limiting a bank's capacity for lending and investment, although this is generally viewed positively from a stability perspective.

Hypothetical Example

Consider "Bank Alpha," a hypothetical financial institution subject to a 5% Adjusted Average Leverage Ratio requirement.

Scenario:

Over a fiscal quarter, Bank Alpha reports the following month-end figures:

• Month 1:
  • Tier 1 Capital: $100 billion
  • Total Adjusted Exposure Measure: $2,000 billion
• Month 2:
  • Tier 1 Capital: $102 billion
  • Total Adjusted Exposure Measure: $2,050 billion
• Month 3:
  • Tier 1 Capital: $104 billion
  • Total Adjusted Exposure Measure: $2,080 billion

Calculation:

1. Calculate Average Tier 1 Capital:
   $$ \text{Average Tier 1 Capital} = \frac{($100 \text{ billion} + $102 \text{ billion} + $104 \text{ billion})}{3} = \frac{$306 \text{ billion}}{3} = $102 \text{ billion} $$

2. Calculate Average Total Adjusted Exposure Measure:
   $$ \text{Average Total Adjusted Exposure Measure} = \frac{($2,000 \text{ billion} + $2,050 \text{ billion} + $2,080 \text{ billion})}{3} = \frac{$6,130 \text{ billion}}{3} \approx $2,043.33 \text{ billion} $$

3. Calculate Adjusted Average Leverage Ratio:
   $$ \text{Adjusted Average Leverage Ratio} = \frac{$102 \text{ billion}}{$2,043.33 \text{ billion}} \approx 0.0499 = 4.99% $$

Interpretation:

In this hypothetical example, Bank Alpha's Adjusted Average Leverage Ratio is approximately 4.99%. If the regulatory requirement is 5%, Bank Alpha is slightly below the target, indicating a need to increase its Tier 1 capital or reduce its total adjusted exposures to meet regulatory standards. This demonstrates how the ratio provides a clear, quantitative snapshot of a bank's overall leverage.

Practical Applications

The Adjusted Average Leverage Ratio is primarily a tool for prudential regulation and supervision within the banking industry. Its practical applications include:

• Regulatory Compliance: Banks, particularly large and systemically important ones, must comply with minimum Adjusted Average Leverage Ratio requirements set by national and international bodies like the Basel Committee. Failure to meet these thresholds can result in supervisory actions, penalties, or restrictions on capital distributions.¹³, ¹⁴
• Capital Planning and Stress Testing: Financial institutions incorporate this ratio into their internal capital adequacy assessment processes (ICAAP) and stress tests. This helps them understand how adverse economic scenarios might impact their leverage position and ensure they maintain sufficient capital buffers.
• Market Discipline: Public disclosure of the Adjusted Average Leverage Ratio allows investors, analysts, and rating agencies to assess a bank's financial health and compare its leverage across peers. Transparency in this ratio, alongside risk-weighted assets ratios, contributes to market discipline by enabling stakeholders to hold banks accountable for their balance sheet management.
• Lending Decisions: While not a direct input for individual loan decisions, the overall capital position influenced by the Adjusted Average Leverage Ratio can impact a bank's capacity for new lending and its appetite for credit risk. Maintaining strong capital allows banks to support economic growth by extending credit to businesses and individuals.
• Monetary Policy Transmission: Research suggests that leverage ratios, alongside other balance sheet costs, can influence the transmission of monetary policy through money markets, by affecting banks' incentives and constraints.¹²

Limitations and Criticisms

While the Adjusted Average Leverage Ratio offers a simplified and robust measure of leverage, it also faces several limitations and criticisms:

• Lack of Risk Sensitivity: The primary criticism is its non-risk-based nature. Unlike risk-weighted assets ratios, it treats all assets equally in the denominator, regardless of their inherent risk. A low-risk government bond has the same impact on the ratio as a high-risk corporate loan. This can disincentivize banks from holding low-risk, liquid assets, potentially hindering market liquidity and efficient capital allocation.¹¹
• Disincentive for Certain Activities: Critics argue that a strict leverage ratio can discourage banks from engaging in certain low-risk, high-volume activities that expand their balance sheets, such as prime brokerage services or acting as market makers for U.S. Treasuries, even if these activities are beneficial for market functioning. Some banking executives have argued that proposed leverage ratio reforms are primarily about increasing capacity for banks to support hedge funds in the government debt market.¹⁰
• Potential for Regulatory Arbitrage: While designed to be simple, precise adjustments to the definition of "total adjusted exposure" can still create opportunities for banks to structure transactions in ways that minimize the impact on the ratio without necessarily reducing underlying risk.
• Impact on Lending: Some argue that higher leverage ratio requirements increase the cost of capital for banks, which may then be passed on to borrowers in the form of higher interest rates or reduced lending, potentially hindering economic growth. However, studies have also suggested that the benefits of a higher leverage ratio in reducing the probability and cost of banking crises may outweigh these costs.⁸, ⁹
• Snapshot vs. Average: While the "average" component aims to smooth out daily fluctuations, it might still not fully capture intra-period leverage spikes or specific moments of increased risk not reflected in the averaged figures.

Adjusted Average Leverage Ratio vs. Supplementary Leverage Ratio

The Adjusted Average Leverage Ratio and the Supplementary Leverage Ratio (SLR) are closely related, particularly within the U.S. banking regulatory framework, but there are key distinctions.

The Supplementary Leverage Ratio (SLR) is a specific regulatory leverage ratio introduced as part of Basel III and adopted by U.S. regulators for large financial institutions, especially Global Systemically Important Banks (G-SIBs). It is defined as Tier 1 capital divided by an expanded definition of total leverage exposure, which includes all on-balance sheet assets, certain off-balance sheet exposures, and derivatives.⁶, ⁷ The SLR is typically calculated as an end-of-quarter measure, though disclosure requirements may specify an average of month-end figures within a quarter.⁴, ⁵

The Adjusted Average Leverage Ratio, as a broader term, refers to any leverage ratio calculation that incorporates specific "adjustments" to the exposure measure and is calculated as an "average" over a period. The SLR itself can be considered a type of "adjusted average leverage ratio" when its calculation explicitly includes particular adjustments beyond simple accounting assets (like for derivatives or off-balance sheet items) and is presented as an average over time. For instance, temporary exclusions of U.S. Treasuries and Federal Reserve deposits from the SLR denominator during the COVID-19 pandemic represented a specific "adjustment" to the standard SLR.³

The confusion often arises because the "adjusted" aspect highlights modifications to the denominator (exposure measure) to capture a more comprehensive view of leverage, and the "average" aspect refers to the calculation methodology over time. The SLR is a defined regulatory measure that embodies these characteristics.

FAQs

What is the main purpose of the Adjusted Average Leverage Ratio?

Its main purpose is to serve as a non-risk-based backstop to other capital requirements, ensuring that banks maintain a minimum level of capital against all their exposures, regardless of their perceived riskiness. This helps prevent excessive leverage in the banking system.

How is the "average" component typically calculated?

The "average" component usually involves taking the simple average of the ratio's numerator (Tier 1 capital) and denominator (total adjusted exposure) over a specified period, such as a quarter, often based on month-end figures.¹, ²

Why are "adjustments" made to the exposure measure?

Adjustments are made to provide a more comprehensive and accurate picture of a bank's total leverage. These typically include bringing off-balance sheet exposures, derivatives, and certain securities financing transactions into the calculation, which might not be fully captured by traditional balance sheet measures alone.

Does this ratio replace risk-weighted capital ratios?

No, the Adjusted Average Leverage Ratio does not replace risk-weighted assets ratios. Instead, it complements them. Risk-weighted ratios focus on the specific risks of assets, while leverage ratios provide a broad, non-risk-sensitive floor to capital. Both are essential for a robust regulatory framework.

How does this ratio impact bank lending?

A higher Adjusted Average Leverage Ratio generally means a bank needs to hold more equity relative to its total exposures. While this enhances financial stability, some argue it can increase the cost of capital for banks, potentially affecting their capacity or willingness to extend credit, which could in turn influence economic growth.