Leverage Ratio (Banking)
The banking leverage ratio is a non-risk-based capital adequacy measure under Basel III, calculated as Tier 1 capital divided by a bank's total exposure (on- and off-balance-sheet assets), and is designed to act as a backstop against excessive balance-sheet expansion.
Unlike risk-weighted capital ratios such as the Capital Adequacy Ratio (CAR) or Tier 1 ratio, the leverage ratio does not adjust exposures by risk weights. It treats a AAA-rated government bond and a sub-investment-grade corporate loan as equally contributing to the denominator. This simplicity is its chief advantage: it cannot be gamed through risk-weight optimisation, which banks engaged in extensively before the 2008 crisis by piling into assets with artificially low regulatory risk weights.
The formula is: Leverage Ratio = Tier 1 Capital ÷ Total Exposure Measure. The minimum leverage ratio under Basel III is 3 percent, and the RBI implemented this for Indian banks effective from April 2019. Domestic Systemically Important Banks (D-SIBs) face a higher leverage ratio buffer of 3.5 percent.
The total exposure measure includes on-balance-sheet items at their accounting value (net of specific provisions), derivatives exposure measured by replacement cost plus potential future exposure, securities financing transactions measured by gross assets, and off-balance-sheet items converted to credit equivalent amounts using standardised credit conversion factors. Notably, even items that do not appear on the reported balance sheet — such as undrawn credit commitments and guarantees — are captured, making the leverage ratio a more comprehensive solvency check than it might appear.
Tier 1 capital — which forms the numerator — comprises Common Equity Tier 1 (CET1: paid-up capital, retained earnings, other comprehensive income) plus Additional Tier 1 (AT1: perpetual bonds, preference shares meeting specific Basel criteria). This is the highest-quality, loss-absorbing capital layer.
In the Indian context, public sector banks historically struggled with leverage ratios during periods of large provisioning for NPAs, which eroded Tier 1 capital while assets remained on the balance sheet. Several banks that were placed under the RBI's Prompt Corrective Action framework between 2017 and 2021 also faced leverage ratio breaches. As the NPA cycle cleaned up and banks raised fresh capital, leverage ratios recovered.
For investors, the leverage ratio supplements the risk-based CAR to provide a fuller picture of solvency. A bank can show a healthy CAR by stuffing its balance sheet with government securities (zero risk weight) but still be over-leveraged in absolute terms. The leverage ratio captures this risk. Deterioration in the leverage ratio — even when CAR appears adequate — can be an early signal of over-extension.