Assume, a bank keeps all the deposits collected from the customers in its vaults. It is an ideal situation to a bank that it has large quantity of liquid capital to return the money back to the depositors as and when they demand it. However, keeping customer’s deposits without using doesn’t earn any money to the bank. So bank has to use the debts (deposits from customers) to finance its customers to make profit. The term ‘Leverage’ denotes to the amount of debt a bank/ organization uses to finance assets and the ‘leverage ratio’ is the proportion of debts that a bank has compared to its equity/capital. There are different leverage ratios such as Debt to Equity, Debt to Capital and Debt to Assets.
The Tier 1 capital is the term used to refer core component of capital. The Tier 1 leverage ratio is the relationship between a banking organization’s core capital and its total assets which is useful to assess how much capital comes in the form of debt (deposits in case of banks), and the ability of a bank to meet its financial obligations as they come due. The Tier 1 leverage ratio is calculated by dividing Tier 1 capital by a bank’s average total consolidated assets and certain off-balance sheet exposures. A higher leverage ratio denotes that the bank has to accumulate more capital to finance its assets. In the other words, whenever the banking regulator ask the scheduled commercial banks to maintain higher leverage ratio, banks will have to keep more capital to match with their assets. But higher leverage ratio decreases the profitability of banks because it means restriction on their financing activity to a specific level.
