How is the Basel leverage ratio calculated and why was it introduced alongside risk-based capital requirements?

The Basel III leverage ratio is a simple, non-risk-weighted measure designed as a backstop to the risk-based capital framework. It was introduced because the 2008 financial crisis revealed that some banks had dangerously high leverage despite appearing well-capitalized on a risk-weighted basis.

The Formula:

Leverage Ratio = Tier 1 Capital / Total Exposure Measure

Minimum requirement: 3% (with additional buffers for G-SIBs)

Why Risk-Weighted Ratios Failed:

Before 2008, several banks had Tier 1 ratios above 10% (healthy-looking) but leverage ratios below 2% (dangerously thin). How? By concentrating in assets with low risk weights:

• AAA-rated mortgage-backed securities: 20% risk weight under the SA, or even lower under IRB
• Sovereign bonds: 0% risk weight
• Off-balance-sheet commitments: Low or zero conversion factors

When these 'low-risk' assets suffered unexpected losses, the banks had insufficient actual capital to absorb them because risk weights had dramatically underestimated the true risk.

Total Exposure Measure — What's in the Denominator:

1. On-Balance-Sheet Exposures — All assets at their accounting value (no risk weighting), net of specific provisions and valuation adjustments. No netting of collateral (unlike RWA).

1. Derivative Exposures — Replacement cost plus a measure of potential future exposure (PFE). Under Basel III, this uses the Standardized Approach for Counterparty Credit Risk (SA-CCR).

1. Securities Financing Transactions (SFTs) — Repos, reverse repos, securities lending. Includes both the accounting asset and a measure of counterparty credit risk.

1. Off-Balance-Sheet Items — Undrawn credit facilities, letters of credit, guarantees. Unlike RWA calculations, the leverage ratio uses higher (or no) credit conversion factors — a $1B undrawn credit line counts significantly in the exposure measure.

G-SIB Leverage Buffer:

Global Systemically Important Banks face an additional leverage ratio buffer equal to 50% of their G-SIB risk-weighted surcharge. A G-SIB with a 2% RWA surcharge would need a leverage ratio of 3% + 1% = 4%.

Exam Tip: The FRM tests understanding of WHY the leverage ratio was introduced (catching model risk in risk weights) and the mechanics of the exposure measure (especially off-balance-sheet and derivative treatment).

Practice leverage ratio questions in our FRM Part II resources.