What Is the Tier 1 Leverage Ratio?

The Tier 1 leverage ratio measures a bank's core capital relative to its total assets. The ratio looks specifically at Tier 1 capital to judge how leveraged a bank is based on its assets. Tier 1 capital refers to those assets that can be easily liquidated if a bank needs capital in the event of a financial crisis. The Tier 1 leverage ratio is thus a measure of a bank's near-term financial health.

The Tier 1 leverage ratio is frequently used by regulators to ensure the capital adequacy of banks and to place constraints on the degree to which a financial company can leverage its capital base.

Tier 1 Leverage Ratio Formula

 $\begin{aligned} &\text{Tier 1 Leverage Ratio} = \frac{ \text{Tier 1 Capital} }{ \text{Consolidated Assets} } \times 100 \\ &\textbf{where:} \\ &\text{Tier 1 Capital} = \text{Common equity, retained earnings,} \\ &\text{reserves, plus certain other instruments} \\ \end{aligned}$​Tier 1 Leverage Ratio=Consolidated AssetsTier 1 Capital​×100where:Tier 1 Capital=Common equity, retained earnings,reserves, plus ;certain other instruments​

How to Calculate the Tier 1 Leverage Ratio

1. Tier 1 capital for the bank is placed in the numerator of the leverage ratio. Tier 1 capital represents a bank's common equity, retained earnings, reserves, and certain instruments with discretionary dividends and no maturity.
2. The bank's total consolidated assets for the period are placed in the denominator of the formula, which is typically reported on a bank's quarterly or annual earnings report.
3. Divide the bank's Tier 1 capital by total consolidated assets to arrive at the Tier 1 leverage ratio. Multiply the result by 100 to convert the number to a percentage.

What Does the Tier 1 Leverage Ratio Tell You?

The Tier 1 leverage ratio was introduced by the Basel III accords, an international regulatory banking treaty proposed by the Basel Committee on Banking Supervision in 2009. The ratio uses Tier 1 capital to evaluate how leveraged a bank is in relation to its overall assets. The higher the Tier 1 leverage ratio is, the higher the likelihood that the bank could withstand a negative shock to its balance sheet.

Components of the Tier 1 Leverage Ratio

Tier 1 capital is the core capital of a bank according to Basel III and consists of the most stable and liquid capital as well as the most effective at absorbing losses during a financial crisis or downturn.

The denominator in the Tier 1 leverage ratio is a bank's total exposures, which include its consolidated assets, derivative exposure, and certain off-balance sheet exposures. Basel III required banks to include off-balance-sheet exposures, such as commitments to provide loans to third parties, standby letters of credit (SLOC), acceptances, and trade letters of credit.

Tier 1 Leverage Ratio Requirements

Basel III established a 3% minimum requirement for the Tier 1 leverage ratio, while it left open the possibility of increasing that threshold for certain systematically important financial institutions.

In 2014, the Federal Reserve, the Office of the Comptroller of the Currency (OCC), and the Federal Deposit Insurance Corporation (FDIC) released regulatory capital rules that imposed higher leverage ratios for banks of certain sizes effective as of Jan. 1, 2018. Bank holding companies with more than $700 billion in consolidated total assets or more than $10 trillion in assets under management must maintain an additional 2% buffer, making their minimum Tier 1 leverage ratios 5%.

In addition, if an insured depository institution is being covered by a corrective action framework, meaning it demonstrated capital deficiencies in the past, it must demonstrate at least a 6% Tier 1 leverage ratio to be considered well-capitalized.

Real-World Example of the Tier 1 Leverage Ratio

Below are the capital ratios taken from the financial statements of (BAC) as reported in the bank's Q3 earnings report on Oct. 31, 2018.

• Highlighted in yellow at the bottom of the table, a Tier 1 leverage ratio of 8.3% for the period was reported by the bank.
• We can calculate the ratio by taking the total Tier 1 capital of $186,189 billion (highlighted in green) and dividing it by the bank's total assets of $2.240 trillion (highlighted in blue).
• The calculation is as follows: $\frac{ \$186,189 \text{ billion} }{ \$2.240 \text{ trillion} } \times 100 = 8.3\%$$2.240 trillion$186,189 billion​×100=8.3%
• Bank of America's Tier 1 leverage ratio of 8.3% was well above the requirement of 5% by regulators.

The Difference Between the Tier 1 Leverage Ratio and the Tier 1 Capital Ratio

The Tier 1 capital ratio is the ratio of a bank’s core Tier 1 capital—that is, its equity capital and disclosed reserves—to its total risk-weighted assets. It is a key measure of a bank's financial strength that has been adopted as part of the Basel III Accord on bank regulation.
The Tier 1 capital ratio measures a bank’s core equity capital against its total risk-weighted assets, which include all the assets the bank holds that are systematically weighted for credit risk. The Tier 1 leverage ratio measures a bank's core capital to its total assets. The ratio uses Tier 1 capital to judge how leveraged a bank is in relation to its consolidated assets, whereas the Tier 1 capital ratio measures the bank's core capital against its risk-weighted assets.

Limitations of Using the Tier 1 Leverage Ratio

A limitation of using the Tier 1 leverage ratio is that investors are reliant on banks to properly and honestly calculate and report their Tier 1 capital and total assets figures. If a bank doesn't report or calculate its figures properly, the leverage ratio could be inaccurate. A leverage ratio above 5% is currently what regulators are looking for, but we won't actually know until the next financial crisis hits to find out whether banks are truly able to withstand the financial shock that it causes.

What Is the Tier 1 Leverage Ratio of Major Banks?

A tier 1 leverage ratio above 5% is considered to be an indicator of strong financial health for a bank. Most major banks have a ratio well above 5%- Here are some examples as of Q1 2023:

• Citibank: 8.82
• JPMorgan Chase: 8.60
  Wells Fargo: 8.55
• Bank of America: 7.88

What Is the Minimum Tier 1 Capital Ratio for a Bank?

Under the Basel Accords, banks must have a minimum capital ratio of 8% of which 6% must be Tier 1 capital. The 6% Tier 1 ratio must be composed of at least 4.5% of Common Equity Tier (CET1).

What Is the Difference Between CET1 and Tier 1 Leverage Ratio?

Common Equity Tier 1 (CET1) is a component of Tier 1 capital that is primarily liquid bank holdings such as cash and stock. The CET1 ratio compares a bank's capital against its assets. The other component of Tier 1 capital is known as additional Tier 1 capital (AT1) and is composed of instruments that are not common equity. In other words, AT1 + CET1 = Tier 1 capital.

The Bottom Line

The tier 1 leverage ratio is the relationship between a banking organization's core capital and its total assets. It's calculated by dividing tier 1 capital by a bank's average total consolidated assets. It serves as a measure of a bank's financial strength. Regulators look for a tier 1 leverage ratio above 5% to ensure that a bank is well-capitalized and has enough liquidity on hand to meet its financial obligations.