Why Is Leverage Ratio Used by Regulators?
When Does a Leverage Ratio Arise? mes How Can Leverage Ratio be Calculated? How Should It be Calculated? Its
1 Results, 2 Revenues, 3 risks 4 Capital 5 Transformation 5 Transformation
mes Regulatory Requirement for Leverage Ratio Calculations? WASH
What Is Leverage Ratio (LR)? Leverage ratio (LR) is an easily calculable measure that measures indebtedness relative to assets in any entity and allows easy comparison among different entities.
After the financial crisis, financial institutions learned an important lesson: risk taking cannot guarantee survival for financial services firms.
There must be an indicator which measures the quality and real capacity to absorb losses of capital investments.
How Does Leverage Ratio Form?
One cause of the current global financial crisis has been excessive indebtedness by banks to their clients; that is, between loan funding needs and available capital for lending purposes.
Financial institutions obtain money from creditors on an asset per euro that it’s worth. We recall that banks finance assets (loans granted) using resources (capital) from investors as well as incurring liabilities (debt and deposits).
One way of controlling indebtedness would be requiring additional capital from you when financing assets.
- Results
BBVA earned EUR 709 Million during its inaugural quarter. 2. Revenues
Gross margin increased 14.9% year-on-year at constant rates to reach 5,788 Million Euros (+14%) due to strong recurring income (interest margin plus commissions). 3. Risks
At the end of Q3, BBVA saw its NPL ratio improve to 5.3% from 5.4% in December; coverage remains stable at 74%. 4. Capital Additionally, BBVA achieved a fully loaded CET1 ratio of 10.54% which saw growth by 21 basis points during the quarter. - Transformation
At the close of Q3, digital customer growth exceeded 20% year over year; of this number, 9.4 million mobile customers (an increase of 445% year-on-year).
As pre-crisis regulation took into account measuring an entity’s financial health, maintaining a certain proportion of capital determined by risk-weighted assets (APRs) was sufficient. (‘The Flash: What Is Bank Capital Calculation?) Additionally, debt levels of these entities also played a factor.
Later, during the crisis, it became evident that capital requirements determined through these ratios weren’t sufficient to absorb potential losses; also allowing banks to reach low APRs by using multiple risk valuation models simultaneously.
Thus, many entities exhibited extremely high capital ratios not due to having sufficient funds available; rather it was because their APRs did not accurately represent the risk incorporated in their balance sheets, permitting them to borrow without raising alarm until crisis hit and alarm bells went off.
These institutions compelled businesses to implement aggressive delevering processes that resulted in losses, capital reduction and credit impairment. How Can Leverage Ratio Be Calculated?
Under these circumstances, the Basel III Committee deemed it important to implement a complementary measure – capital quality index – alongside traditional capital ratios to evaluate an entity’s capital quality.
The leverage ratio has emerged as an efficient, straightforward, and standardized way of measuring leverage among businesses, and was adopted by the European Commission in October 2015 as per Basel standards.
The leverage ratio measures the relationship between required Tier 1 regulatory capital (CET1) and total bank assets, including assets off balance sheet. With this ratio in place, controllers aim to achieve two key goals.
Limit excess debt that an entity can assume while providing a complementary measure that reinforces capital requirements regardless of risk. One advantage associated with the ratio’s ease-of-calculation and comparability is covering all risks.
Additionally, capital requirements limit the risks that banks take by keeping assets within safe levels and stopping uncontrollable growth of assets on balance sheets.
Combining leverage ratio and risk-weighted capital ratios may prove key in avoiding future financial crises:
Systemic risk can be reduced through this tool by covering all possible outcomes for an entity and decreasing bank autonomy when undertaking high-risk activities.
Therefore, entities with high risk-weighted asset levels tend to face constraints in meeting regulatory capital needs due to an elevated leverage ratio; those with lower APRs face further restrictions from raising capital because their APR limits them from doing so. [1. Operating Leverage Ratio
Operating leverage ratio is used to assess how income changes with changes in sales volume.
Operating Leverage Ratio can be determined using this formula: Operating Leverage Ratio = Percent Change in EBIT (earnings before interest and taxes) divided by Percent Change in Sales Volume
- Net Leverage Ratio
The net leverage ratio measures the rate at which businesses owe earnings compared to earnings before interest, taxes, depreciation and amortization (EBITDA). It shows how long it would take if debt and EBITDA levels stayed the same over time.
Net Leverage Ratio can be calculated with this formula: Net Leverage Ratio = (Net Debt – Cash Holdings)/ EBITDA. - Debt to Equity Ratio [D:E ratio] The debt-equity ratio measures the ratio between an organization’s liabilities and stockholder equity.
An equity ratio provides a quick snapshot of a business relative to its debt load, using this formula: Debt/Equity Ratio = Liabilities/Shareholder Equity. What Leverage Ratio do Regulators Require?
Basel III has set, for 2018, a minimum leverage ratio of 3%; that means capital must cover at least this proportion of assets.
In December 2015, BBVA published its fully loaded leverage ratio incorporating regulator requirements for 2018 with current data of 6.0%; this represented the highest score among its peer group of firms.
As of September 2015, the overall sector average was 4.5%.
