Leverage Ratio

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Leverage Ratios

A leverage ratio is a financial measurement that assesses how much capital comes in the form of debt (loans) compared to other sources. There are different leverage ratios that are used for different purposes. The most important leverage ratios for banks and other companies are as follows:

1. Financial Leverage (Debt-to-Equity Ratio):

• Shows how much of a company's financing comes from debt versus equity
• Higher ratios indicate more debt financing and higher risk
• Generally, a ratio above 2.0 may be concerning, though this varies by industry

2. Assets-to-Equity Ratio:

• Shows how much of a company's assets are financed by shareholders versus debt
• Higher ratios indicate more aggressive financial structuring

3. Banking/Regulatory Leverage:

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• Used by banks under Basel III requirements
• Banks typically need to maintain a minimum ratio (often 3% or higher)

4. Operating Leverage:

• Measures how changes in revenue affect operating income
• Higher fixed costs relative to variable costs mean higher operating leverage
• Higher operating leverage makes earnings more volatile as sales change

Key considerations when analyzing leverage:

• Industry standards vary significantly, so it is important to consider the appropriate benchmark when analyzing leverage ratios.
• Higher leverage amplifies both profits and losses, which may lead to unwanted volatility during unstable economic conditions.
• Interest coverage ability is crucial, as a low interest coverage rate may lead to an increased risk of default.
• The company's cash flow stability matters as much as its interest coverage ability, as unstable cash flows may also increase the risk of default.

Excessive leverage can lead to:

• Higher interest expenses: Leverage comes from debt that usually requires interest to be paid on. The higher the leverage, the more debt the company has, and the more interest the company has to pay in total and relative to its assets.
• Reduced financial flexibility: Debt reduces the income and capital available to pursue emerging opportunities. This loss of financial flexibility can result in significant opportunity costs, as highly leveraged companies may be forced to pass on profitable projects due to their debt obligations.
• Greater vulnerability during economic downturns: Debt amplifies both gains and losses. During economic downturns, high debt service costs can severely impact cash flow and profitability when companies can least afford it.
• Increased risk of bankruptcy: When a bank or company cannot meet its debt service obligations, it faces bankruptcy. Bankruptcy risk increases with higher leverage and deteriorates further during adverse economic conditions.
• Potential credit rating downgrades: A high amount of debt and high leverage ratios increase a bank's or a company's credit risk. If lenders believe the risk is too high, they will offer less money and at a higher interest rate, which limits financing opportunities and increases the cost to finance.

Banking leverage refers to the relationship between a bank's core capital and its total assets. In simple terms, it's how much a bank can "stretch" its capital to support its assets (mainly loans). A higher leverage means the bank uses more borrowed money than its own capital.

Leverage Ratio for Canadian domestic systematically important banks (D-SIBs)

For Canadian banks, leverage is primarily regulated through two key metrics:

1. The Leverage Ratio (LR)

• This is a simpler, non-risk-weighted measure
• According to OSFI, the regulator of Canadian financial institutions, Canadian banks must maintain a minimum leverage ratio of 3%. Note that OSFI has the discretion to allow an institution to descend to a lower leverage ratio or to require it to ascend to or maintain a higher leverage ratio.

• Calculated as:

  Leverage ratio = Capital Measure/Exposure Measure,

  In other words: Leverage Ratio = Tier 1 Capital / Total Exposure

• Total exposure includes both on-balance sheet assets and off-balance sheet items.

2. The Risk-Based Capital Ratios also set by OSFI

• Common Equity Tier 1 (CET1) ratio: Must be at least 7%
• Tier 1 Capital ratio: Must be at least 8.5%
• Total Capital ratio: Must be at least 10.5%
• These ratios are risk-weighted, meaning different assets are assigned different risk levels.
• These ratios include the minimum capital requirement and the Capital Conservation Buffer, while they exclude the 3.5% Domestic Stability Buffer (DSB) and the 1% surcharge.

OSFI has divided Canadian depository institutions into domestic systematically important banks (D-SIBs) and small and medium-sized banks (SMSBs). D-SIBs include Canada’s big six banks, and all others are considered SMSBs. The dividing line is $100 B in total assets. Calculating risk-weighted assets (RWA) is quite complicated, especially when it comes to market risk, which differs between D-SIBs and SMSBs.

Common Equity Tier 1 (CET1) Capital Ratio for Canadian Systematically Important Banks (D-SIBs)

Canadian banks are known for being more conservatively leveraged than many international peers, which helped them weather the 2008 financial crisis better than banks in other countries. The Office of the Superintendent of Financial Institutions (OSFI) typically requires Canadian banks to maintain higher capital levels than the international minimums set by Basel III requirements.

Some distinguishing features of Canadian bank leverage regulation:

• Domestic Systemically Important Banks (D-SIBs) must hold an additional 1% capital buffer
• OSFI maintains stricter definitions of capital than many other jurisdictions
• Canadian banks typically operate with significant voluntary buffers above minimum requirements
• Stress testing is regularly conducted to ensure banks can maintain adequate capital even under adverse scenarios

Tier 1 Capital Ratio for 5 Canadian banks

What does TLAC stand for?

TLAC stands for Total Loss-Absorbing Capacity. It's an international standard developed by the Financial Stability Board (FSB) after the 2008 financial crisis to ensure that global systemically important banks (G-SIBs) have enough capital and debt that can be converted to equity in case of a crisis.

For Canadian banks that are designated as D-SIBs (Domestic Systemically Important Banks), they must maintain minimum TLAC ratios as required by OSFI:

• Risk-based TLAC ratio: Must be at least 21.5% of risk-weighted assets
• TLAC leverage ratio: Must be at least 6.75% of leverage exposure

TLAC includes:

• Regulatory capital (like Common Equity Tier 1)
• Certain types of long-term debt that can be converted to equity
• These instruments must be able to absorb losses before more senior debt and deposits

The purpose is to ensure that if a major bank fails, it can be recapitalized through the conversion of TLAC instruments into equity without using taxpayer money for bailouts or disrupting critical banking services.

What does TLCA stand for?

TLCA stands for Trust and Loan Companies Act. This Canadian federal statute regulates trust companies and loan companies under federal jurisdiction. The Act provides the legal framework for the incorporation, operation, and supervision of trust and loan companies in Canada.

The TLCA is one of several key pieces of legislation that OSFI uses to regulate financial institutions in Canada, along with:

• Bank Act (BA)
• Insurance Companies Act (ICA)
• Cooperative Credit Associations Act (CCAA)