What is a leverage ratio

Leverage ratio

The Deutsche Bank is not only considered a systemically important institution, the IMF has classified it as the riskiest bank in the world. This knowledge does not result from subjective perception, but resulted from the “leverage ratio”, among other things. What is it all about?

What does the leverage ratio indicate?

The leverage ratio quantifies the level of indebtedness of a company. The leverage ratio is defined as the quotient of regulatory core capital and the “total risk exposure size”. The total risk position size is made up of unweighted assets, off-balance sheet positions including derivatives.

As a reminder, Deutsche Bank has derivatives on its books for 50 trillion euros.

The formula for determining the leverage ratio is quite slim:

Leverage ratio = (debt capital ÷ equity) * 100

The higher the quotient, the higher the level of indebtedness of a company.

Purpose of the leverage ratio

The leverage ratio is particularly important for a loan request. As part of the credit check, the key figure shows how high the company's level of indebtedness is and how much debt it already has. The aim of this ratio is to act as a corrective, among other things, when it comes to defining risk-based capital. The leverage ratio is one of the newly defined indicators of the Capital Requirements Regulation (CRR) (1) as a result of the financial market crisis. It is used to check the maximum regulatory debt of a bank.

The moral hazard theorem

The term moral hazards theorem appears again and again in connection with the leverage ratio. The basis of the theorem is that with increasing indebtedness the equity providers can leverage their profit in the sense of a CFD business. In contrast, the risks are shifted to the creditors and possible state security systems. This shift is caused by restricted lending by indebted banks and a short-term reduction in risky securities. However, this in turn has a destabilizing effect for the entire market. The own equity ratio of the indebted bank is strengthened in return.

Criticism of the leverage ratio

Critics of the leverage ratio complain that changing the parameters leads to a risk leveling that weights all risks equally. This in turn leads to an equity backing for the loans that were previously not weighted in relation to equity. However, especially with regard to the business policy of the state development banks, it has been shown that a one-dimensional code cannot be valid for every bank.

Problem with the development banks

In Germany there are 17 promotional banks, whose task is to implement national and European promotional measures. These banks are all publicly owned institutions, i.e., regardless of how the capital base is equipped, the loans are covered by public funds. The CRR was introduced in order to better control internationally active commercial banks. However, the German development banks also fall under this control. While the Deutsche Bank would only get limited backing from the state, the situation is different with a development bank. The state is the direct or indirect owner.

Leverage ratio counterproductive in the public sector

A curtailment of the business activities of these institutes on the basis of the leverage ratio, if this turns out to be too critical, would be counterproductive in relation to the request and object of these institutes. From the facts of the owner constellation it follows that the loans of the development banks are doubly secured. On the one hand, the borrowers have to provide collateral, on the other hand, the respective federal states give loan default guarantees. A capital backing for the loans granted by these specialist institutions is therefore superfluous. The financial crisis showed that the development banks are extremely stable. The implementation of the CRR would have a negative rather than a stabilizing effect in the event of a volatile economy that needs impetus, for example from residential construction.

Implementation at promotional banks is being reviewed again

After the latest report from the European Banking Authority (2), the European Commission is facing a decision. Either it continues to adhere to a uniform regulation for all institutions, or it differentiates between private commercial banks and public institutions.

Additional information

Author: Eric Funke