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Moutusi Sau
Senior Associate, Program Research Analyst, Center for Financial Markets
Moutusi Sau is a senior associate at the Milken Institute's Center for Financial Markets in Washington, D.C. She conducts research and helps execute programmatic activities on Milken Institute projects involving new tools for access to capital, strengthening capital markets in developing countries, and housing finance reform.
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Are higher leverage ratios behind banks’ lower return on equity?

By: Moutusi Sau
December 04, 2014
   
   

Since the financial crisis, leverage ratios have been a point of contention between regulators and the big banks. These ratios, which compare a bank’s tier 1 capital to its average total consolidated assets, are used to determine the strength of a bank’s balance sheet and degree to which it can access its core capital assets. Thus, the ratio serves as an important tool to evaluate capital adequacy.

According to the Basel III regulatory framework of the Basel Committee on Banking Supervision, banks should maintain a tier 1 leverage ratio of at least 3 percent. Additionally, global systemically important banks in the United States (U.S.-GIBs) must comply with a set of rules called the supplemental leverage ratio (SLR), which is set at 5 percent. These institutions will have to publicly disclose their compliance with both SLR and Basel III leverage ratios by New Year’s Day. Thus, the requirements for U.S. G-SIBs are substantially more stringent than those that apply to their overseas counterparts. Yet that could change soon because European regulators are under pressure from officials around the world to impose stricter rules on continental banks. 

Leverage ratios have often been criticized for their use as a measure of bank strength. They are regarded as a rigorous test but do not take loan risk into account. However, leverage tests have been the basis of many costly regulations imposed on the banks in the wake of the crisis, and they’ve contributed to the weakness in lending seen in recent years. The brunt of these regulations has fallen on G-SIBs, which are reducing their risk-weighted asset bases by changing how they raise capital for operations. Many banks have retained profits or issued new shares to comply with the new regulations instead of raising capital by debt. Investor returns have also been hurt because the tighter regulatory regime has reduced dividend payouts and curbed share repurchases.

As we can see from the accompanying chart, return on equity has been trailing for all the banks since the regulations were implemented, although broader economic conditions have factored into this trend as well. Wells Fargo is the only bank whose ROE even slightly surpasses the tier 1 capital ratio. In this environment, many banks are trying to shift away from traditional lending toward lines of business with lighter public oversight, such as asset management. These new approaches are meant to ensure profitability as well as move banks outside the focus of regulators, who, after all, are attempting to avoid the mistakes that contributed to the financial meltdown.

View interactive chart.

 

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Sources: Bloomberg, Milken Institute.


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