Case 039Capital and regulationWarm up

A bank's risk-based capital ratio looks comfortable. Compute its leverage ratio from on-balance-sheet, derivative and off-balance-sheet exposure, and explain why the measure ignores risk weights on purpose.

The situation

Tesvara Bank has Tier 1 capital of Rs 3,000 crore. Its on-balance-sheet exposures total Rs 60,000 crore, derivatives add Rs 5,000 crore of exposure, and off-balance-sheet items such as undrawn commitments and guarantees add Rs 10,000 crore after credit conversion factors.

Much of the book is government bonds, secured home loans and highly rated corporates, so its risk-weighted assets are only Rs 20,000 crore and its Tier 1 capital ratio is 15%. Use an illustrative leverage ratio minimum of 4%; confirm the level your regulator applies.

Your task

What is Tesvara's leverage ratio, how much room does it have, and why does the regulator want a measure that ignores risk weights?

Quick check

What is Tesvara's leverage ratio?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

Tesvara's leverage ratio is exactly 4.0%, on the illustrative minimum with no room to grow. Tier 1 of Rs 3,000 crore over Rs 75,000 crore of exposure, including derivatives and off-balance-sheet items, gives 4.0%, even though the same capital is 15% of risk-weighted assets. The leverage ratio ignores risk weights deliberately: it is a backstop that still bites if the weights, or the models behind them, turn out to be wrong.

Step 1How is the leverage ratio built?

Tier 1 capital over total exposure, with every exposure counted at face value. Tesvara's exposure is Rs 60,000 crore on balance sheet, Rs 5,000 crore for derivatives and Rs 10,000 crore off balance sheet, Rs 75,000 crore in all, and Rs 3,000 crore over that is 4.0%. The off-balance-sheet line matters: an undrawn credit line is converted using a credit conversion factorThe share of an undrawn commitment or guarantee that is expected to turn into an actual exposure, used to count off-balance-sheet items in exposure measures. because customers draw lines exactly when they are in trouble.

Same Rs 3,000 crore of Tier 1: 15% of risk-weighted assets, 4% of exposureOn balance sheet 60,000derivatives 5,000off balance sheet 10,000ExposureRs 75,000 crTier 1 3,000 = 4.0% of exposure: exactly the minimumRWA 20,000Risk-weightedRs 20,000 crTier 1 3,000 = 15.0% of RWA: looks comfortableBoth bars drawn to the same scale; the red and lime slivers are the same Rs 3,000 crore
Tesvara's Rs 3,000 crore of Tier 1 capital is 15.0% of its Rs 20,000 crore of risk-weighted assets but only 4.0% of its Rs 75,000 crore of total exposure, exactly at the illustrative 4% leverage minimum.
Step 2How much room does Tesvara have?

None. At exactly 4.0%, every extra rupee of exposure needs four paise of new Tier 1 capital, however safe the asset. Growing by Rs 5,000 crore, even in government bonds with a zero risk weight, needs Rs 200 crore more Tier 1. Holding a buffer of half a point, 4.5%, would need Rs 375 crore now. So for Tesvara the leverage ratio, not the risk-based ratio, is the binding constraint, which is common for banks full of low-risk-weight assets.

Step 3Why ignore risk weights on purpose?

A household that borrows forty times its savings to buy only safe fixed deposits is still one surprise away from ruin, because being wrong about safe is the surprise. Risk weights can be wrong, gamed or out of date, and assets thought safe can turn out not to be; the leverage ratio sets a floor on capital that does not depend on any of those judgements. Before the 2008 crisis, several banks with healthy risk-weighted ratios were leveraged many times over through assets carrying low weights. Tesvara's RWA density, 26.7%, says its models and the standard weights see little risk; the leverage ratio says the bank still cannot run more than 25 rupees of exposure on each rupee of Tier 1.

State the limitation too. Because it treats a government bond and an unsecured loan the same, a binding leverage ratio can push a bank toward riskier assets that earn more for the same capital. That is why regulators use it alongside risk-based ratios, never instead of them.

Where candidates lose it

The common slip is to quote the 15% Tier 1 ratio as the answer, or to divide by on-balance-sheet assets only and get 5%. The leverage measure counts derivatives and off-balance-sheet items too.

The second is to call the leverage ratio a cruder version of the risk-based ratio. It is deliberately a different test, a check on the risk weights themselves, and interviewers want to hear that purpose.

What the interviewer asks next

  • Tesvara wants to add Rs 10,000 crore of government bonds. What does it need to do first?
  • Why are undrawn credit lines converted into exposure rather than ignored?
  • How can a binding leverage ratio change a bank's appetite for low-risk assets?

Company names and figures are illustrative.