Banks are among the most indebted institutions in the United States. Combined with fractional reserve banking and the Federal Deposit insurance Corporation (FDIC), the defense made the banking environment with limited risks of lending.
To compensate for this, three separate regulatory bodies, the Federal Deposit insurance Corporation, the Federal reserve and the Comptroller of the currency, consideration and limitation of the leverage ratio for us banks. This means that they limit how much money a Bank can lend relative to how much capital the Bank dedicates its assets. The level of capital is important because banks can “write” a major part of its assets, if the total value of the assets will fall. Assets financed by debt, cannot be written as bondholders and Bank depositors are owed these funds.
What is leverage?
It’s not very useful to only look at the total amount of Bank loans. Without additional context, it’s too hard to know if the Bank is excessively used. Regulators to overcome this problem by using the ratio of assets to equity on the balance sheet of the Bank, or “leverage.” A higher leverage ratio means that the Bank should use more capital to Finance their assets, at least relative to the total amount of borrowed funds.
The Bank lends the money “borrowed” from the customers that the money kept there. In a sense, all these deposits are Bank loans that can be recalled at any time. Banks are also other more traditional lenders. Leverage is used to capture just how much debt the Bank relative to its capital, in particular, “tier 1 capital”, including ordinary shares, retained earnings and certain other assets.
As in any other company, is considered safer for the Bank to have a higher leverage ratio. The theory is that the Bank should use its own capital to make loans or investments or to sell its most leveraged or risky assets. This is because there are fewer creditors and/or less risk of default if the economy turns South and the investments or loans are not paid off.
Banking regulation on the performance of leverage
Banking rules for the ratio of leverage is very difficult. The Federal reserve has established guidelines for Bank holding companies, although these restrictions vary depending on the assigned rating for the Bank. Overall, banks that experience rapid growth or face operational or financial difficulties are required to maintain higher ratios.
There are several forms of capital requirements and minimum safety factors placed on us banks via the FDIC and the Comptroller of the currency, which have the indirect effect of the ratio of own and borrowed funds. The level of attention paid to the ratio of debt to equity has increased since the great recession of 2007-2009, with concern about major banks, “too big to fail” serving as a calling card to make banks more solvent.
These constraints naturally limit the amount of the loans, because it is more difficult and more expensive for the Bank to raise capital than debt funds. Higher capital requirements may reduce the dividends or dilute the value of shares if the shares are issued.