What Is a Leverage Ratio?
It is not very useful to only look at the total amount of loans made by a bank. Without additional context, it is too difficult to know if a bank is overly leveraged. Regulators overcome this by using the ratio of assets to capital on the bank's balance sheet, or its "leverage ratio." A higher leverage ratio means the bank has to use more capital to finance its assets, at least relative to its total amount of borrowed funds.
A bank lends out money "borrowed" from its customers who deposit money there. In a sense, all of these deposits are loans made to the bank that are callable at any time. Banks often have other, more traditional creditors as well. The leverage ratio is used to capture just how much debt the bank has relative to its capital, specifically "Tier 1 capital", including common stock, retained earnings and select other assets.
As with any other company, it is considered safer for a bank to have a higher leverage ratio. The theory is that a bank has to use its own capital to make loans or investments or sell off its most leveraged or risky assets. This is because there are fewer creditors and/or less default risk if the economy turns south and the investments or loans are not paid off.
Banking Regulations on Leverage Ratios
Banking regulations for leverage ratios are very complicated. The Federal Reserve created guidelines for bank holding companies, although these restrictions vary depending on the "rating" assigned to the bank. In general, banks that experience rapid growth or face operational or financial difficulties are required to maintain higher leverage ratios.
There are several forms of capital requirements and minimum reserve ratios placed on American banks through the FDIC and the Comptroller of the Currency that indirectly impact leverage ratios. The level of scrutiny paid to leverage ratios has increased since the Great Recession of 2007-2009, with the concern about large banks being "too big to fail" serving as a calling card to make banks more solvent.
Read more: http://www.investopedia.com/ask/answers/111414/how-do-leverage-ratios-help-regulate-how-much-banks-lend-or-invest.asp#ixzz3dDhXgRMG