Why does Basel III include a leverage ratio when we already have risk-weighted capital ratios?

The leverage ratio exists precisely because risk-weighted ratios can be gamed or miscalibrated. Here's the core logic:

The Problem with RWA-Only Measures

Before the 2008 crisis, many banks showed healthy CET1/RWA ratios — sometimes above 10% — while running actual leverage of 30:1 or higher. How? By loading up on assets that carried low risk weights (e.g., AAA-rated mortgage-backed securities at 20% weight, sovereign debt at 0%). When those 'low-risk' assets collapsed, the thin equity cushion was wiped out.

The Leverage Ratio Formula:

Leverage Ratio = Tier 1 Capital / Total Exposure Measure

The minimum under Basel III is 3%. The total exposure measure includes:

• On-balance-sheet assets (no risk weighting)
• Derivative exposures (using SA-CCR or CEM)
• Securities financing transactions (repos, securities lending)
• Off-balance-sheet items (committed credit lines, guarantees) at their credit conversion factors

Example: Castlebridge Bank has:

• Tier 1 capital: $12 billion
• On-balance-sheet assets: $300 billion
• Derivative exposures (SA-CCR): $25 billion
• Off-balance-sheet: $75 billion

Leverage Ratio = $12B / ($300B + $25B + $75B) = $12B / $400B = 3.0% — right at the minimum.

Why it matters:

1. Backstop against model risk — Risk weights depend on models that can be wrong
2. Reduces regulatory arbitrage — Banks can't game the denominator with risk-weight optimization
3. Simple and transparent — Investors and regulators can compare banks directly
4. G-SIBs face higher minimums — In many jurisdictions, G-SIBs must hold 50% of their G-SIB surcharge as an additional leverage buffer

For FRM Part II, know the formula, the exposure components, and why the leverage ratio complements rather than replaces risk-weighted measures.

Explore our FRM course for more regulatory capital deep-dives.