How do leverage ratios help to regulate how much banks lend or invest?

Banks are among the most leveraged institutions in the United States. The combination of fractional-reserve banking and Federal Deposit Insurance Corporation (FDIC), protection has produced a banking environment with limited lending risks.

To compensate for this, three separate regulatory bodies, the FDIC, the Federal Reserve and the Comptroller of the Currency, review and restrict the leverage ratios for American banks. This means they restrict how much money a bank can lend relative to how much capital the bank devotes to its own assets. The level of capital is important because banks can "write down" the capital portion of their assets if total asset values drop. Assets financed by debt cannot be written down because the bank's bondholders and depositors are owed those funds.

It is not very useful to look only at the total amount of loans made by a bank. Without additional context, it is too difficult to know if a bank is overly leveraged. Regulators overcome this problem by using the ratio of assets to capital on the bank's balance sheet, or its "leverage ratio." A higher leverage ratio means the bank has to use more capital to finance its assets, at least relative to its total amount of borrowed funds.

A bank lends out money "borrowed" from the clients who deposit money there. In a sense, all of these deposits are loans made to the bank that are callable at any time. Banks often have other, more traditional creditors as well. The leverage ratio is used to capture just how much debt the bank has relative to its capital, specifically "Tier 1 capital," including common stock, retained earnings and select other assets.

As with any other company, it is considered safer for a bank to have a higher leverage ratio. The theory is that a bank has to use its own capital to make loans or investments or sell off its most leveraged or risky assets. This is because there are fewer creditors and/or less default risk if the economy turns south and the investments or loans are not paid off.

Banking regulations for leverage ratios are very complicated. The Federal Reserve created guidelines for bank holding companies, although these restrictions vary depending on the rating assigned to the bank. In general, banks that experience rapid growth or face operational or financial difficulties are required to maintain higher leverage ratios.

There are several forms of capital requirements and minimum reserve ratios placed on American banks through the FDIC and the Comptroller of the Currency that indirectly impact leverage ratios. The level of scrutiny paid to leverage ratios has increased since the Great Recession of 2007-2009, with the concern about large banks being "too big to fail" serving as a calling card to make banks more solvent.

These restrictions naturally limit the number of loans made, because it is more difficult and more expensive for a bank to raise capital than it is to borrow funds. Higher capital requirements can reduce dividends or dilute share value if more shares are issued.