# The Average Leverage Ratio across the UK Banking System: 2007 vs. Now

## By Kevin Dowd

### 3rd June 2016

### Summary:

There has been only a modest increase in banks’ capital standards since 2007 and UK banks’ leverage ratios are still very low. These leverage ratios indicate that UK banks are highly exposed to a renewed financial crisis.

The leverage ratio is the ratio of a bank’s core capital to some measure of its total amount ‘at risk’, traditionally taken as the bank’s total assets. Other things equal, the higher the leverage ratio, the stronger the bank.

To assess the state of financial health of the UK banking system and the extent to which it has recovered since 2007, two key quantitative questions are:

**Question 1:** What is the latest available best estimate of the average leverage ratio across the UK banking system?

**Question 2:** How has the average leverage ratio across the UK banking system changed since 2007?

Current average UK bank leverage ratio

To estimate banks’ core capital, we have a choice between the following available capital measures: Total Shareholder Equity (TSE, which itself comes in a variety of alternative forms), Common Equity Tier 1 capital (CET1) and Tier 1 capital (T1).

To illustrate, consider Barclays’ 2014 Annual Report. On p. 186, this report presents a table that starts with an item called ‘Shareholders’ equity (excluding non-controlling interests)’ that can be interpreted as TSE. It reports a value for that item equal to £59,567m. There then follows a bunch of deductions and a little further below we get a figure for ‘fully loaded’ CET1 of £41,453m. (‘Fully loaded’ means that the number is constructed using Basel III rules when Basel III is fully phased-in.) There follow further adjustments and a couple of tables later on p. 189 we get a number for fully-loaded T1 capital equal to £46bn.

Given that we are interested in core capital for bank solvency purposes, the best of these would be the narrowest.[2] The narrowest available is CET1, which is the least ‘polluted’ by softer capital instruments. We can think of CET1 as approximately equal to Tangible Common Equity plus realised earnings, accumulated other income and other disclosed reserves,[3] but even CET1 is not ideal for several reasons:

- Under Basel III, banks are allowed to include some additional ‘softer’ capital instruments in their reported CET1 capital up to a maximum of 15% of the reported CET1 number. This ‘sin bucket’ consists of Deferred Tax Assets (DTAs), Mortgage Servicing Rights and investments in other financial institutions.[4]
- In the UK CET1 is reported under International Financial Reporting Standards (IFRS) and these are subject to some serious flaws. These flaws include deficiencies in the provisions that IFRS makes for expected losses (see Tim Bush, UK and Irish Banks Capital Losses – Post Mortem, Local Authority Pension Fund Forum, 2011) and its vulnerability to the manipulation of retained earnings (see Gordon Kerr in his Law of Opposites, Adam Smith Institute, 2011).

For the denominator, we have a choice between Total Assets (TA) and the new(ish) Basel III denominator, the Leverage Exposure (LE).[5] The next table allows us to compare these two measures:

**Table 1: Total Assets vs. Leverage Exposure, end-2015Q3**

As we can see, there isn’t much difference between the TA and LE numbers.

If we take data from Annex 1 of the Bank of England’s 2015 stress test report, supplemented as appropriate by total assets data from the banks’ latest interim reports as explained in the notes to Table 1, we get the following results for the banks’ average leverage ratios:[6]

- If we use CET1 in the numerator and Total Assets as the denominator, the average leverage ratio for end-2015Q3 is 4.39%.
- If we replace the denominator with the Leverage Exposure the corresponding average leverage ratio is 4.32%.[7]

Thus, our best available book-value estimate of the banks’ average leverage ratio using latest available data is in the range 4.32% to 4.39% depending on the choice of denominator.

For convenience, lets take our best estimate to be the average of these two figures, i.e., 4.355%, and round this up to 4.36%.

However, as just noted, these are book-value estimates meaning that they are the values taken from the banks’ annual reports or interim accounting statements. Corresponding to these are market-value estimates, which are the estimates reflected in bank stock market prices. We can obtain these by adjusting the book-value estimates by the relevant price-to-book ratios. According to the Bank of England’s data, the average price-to-book ratio for UK banks in September 2015 was 0.84.[8] Therefore, the market-value of our best leverage ratio estimate – the one using CET1 in the numerator – is 0.84 times 4.36% = 3.66%.

The question is then: which is better, book value or market value? I would suggest the latter in this context, because the latter incorporates all information available to the market, whereas the book value merely reflects the information in the relevant annual report or interim statement. So, for example, if a bank is known to have some problem that is not reflected in its most recent accounts (e.g., because of some recent bad news, or because the market does not believe those accounts), then the market value will reflect that information, but the book value will not.[9] More generally, the price-to-book ratio reflects the extent to which the market ‘believes’ the book-value numbers. In the present context, the price-to-book ratio of 0.84 suggests that the market believes that average bank equity is only worth 84% of the book value.

In short, *my best raw-data-based estimate of UK banks’ average leverage ratio at the end of 2015Q3 is the market-value of the CET1-based leverage ratio, i.e., 3.66%.*

Moreover, because of the sin bucket and inflated realised earnings issues raised earlier, we can safely say that the true figure would be lower and possibly considerably lower than 3.66%.[10] In addition, the denominator is underestimated because it omits many off-balance-sheet risk exposures, and this bias *further* inflates the estimated leverage ratio relative to its ‘true’ value.

### How has the UK banks’ average leverage ratio changed since 2007?

This question is a difficult one to answer because of the changes in the both the numerator and denominator measures over this period. Consider the main candidate measures to choose from and the data available:

*Total shareholder equity and total assets*: we have data on these measures that go well back, the main break in these series being caused by the introduction of IFRS in 2005.

*Core Tier 1 capital*: this measure was the core capital measure under Basel II. We have this series for the earlier years but it was discontinued in 2013 with the move towards Basel III.

*Tier 1 capital and CET1 capital*: these are the new core capital measures introduced under Basel III, but some institutions (e.g., Nationwide and Santander) did not begin to report them in their Annual Reports until 2014.

*Leverage exposure*: this measure is the denominator introduced by Basel III to replace total assets, but some banks did not start reporting this measure until 2014.

Consequently, the only leverage ratio measure for which we have any continuous time series across all the banks since 2007 is the ratio of TSE to TA.

*Leverage ratios using TSE and TA since 2007*

Actually, there is no single commonly accepted ratio of TSE to TA; instead, there is a *family* of them. A diverse family it is too: there are at least five different estimates of UK banks’ TSE/TA ratios in 2007. Two of them come from a letter from a Bank of England official (whose name I cannot discern from the signature at the bottom)[11] to Mr. Andrew Tyrie MP as chair of the Treasury Select Committee dated 12 January 2012:

- The first is the ‘[S]imple aggregate leverage ratio of major UK banks’, defined in a footnote as “Total peer group assets over total peer group equity”: this has an average 2007 value of 35.6. Note that this leverage ratio has assets in the numerator and equity in the denominator, whereas it is now standard practice to have equity in the numerator and assets (or LE) in the denominator. The number 35.6 then corresponds to a leverage ratio (as I have defined it) of 1/35.6 = 2.81%.
- The second is the ‘[A]ggregate leverage ratio of major UK banks’, explained in a footnote as follows: “This is our preferred measure of leverage, but is not available for 1997-2007. It includes only high-quality capital, and adjusts total assets to reflect only those assets which put capital at risk. In addition it allows easier comparison with banks reporting under US accounting standards. It is measured as total peer group assets (adjusted for cash items, tax assets, goodwill and intangibles and with derivatives netted according to US GAAP rules) divided by total peer group capital (including total shareholders' equity adjusted for minority interest, preference shares, goodwill and intangibles).” The value of this leverage ratio is 33.3, corresponding to a ‘standard’ leverage ratio (with equity in the numerator, etc.) of 1/33.3 = 3%.

A third estimate comes from Chart 4.1 in the June 2010 *Financial Stability Report,* which suggests that the leverage ratio for 2007 was about 4.3%. The context of this chart indicated that this leverage ratio was based on some simple TSE to TA ratio and correspondence with the Bank confirms that this is the case. However, the number is actually 4.36% rather than the 4.3% I had inferred from the Bank’s chart.

However, to quote a Bank of England official with whom I have been corresponding on this subject, the Bank now uses a slightly tighter measure of simple leverage than that used in the 2010 Financial Stability Report, because we now strip out non-controlling interests from the shareholders equity measure used in the numerator. Had we taken this approach in 2007 it would have shown the average leverage ratio of the UK banking system to be 3.6% rather than 4.3%. Hence based on this consistent simple leverage measure, we can say that the average leverage ratio of the UK banking system has increased from 3.6% in 2007 to 6.3% in H1 2015 [or 2015Q1].

This information is very helpful. A rise from 3.6% to 6.3% indicates a 75% increase in the leverage ratio between 2007 and 2015Q1.

The series he cites is to be found on the aforementioned Excel workbook file ‘ccbdec15.xlsx’ here (accessed 9 March 2016) on the spreadsheet ‘2. Leverage ratios’ under the B column.

However, the same workbook file also contains another leverage ratio time series: on the sheet ‘9. Bank equity measures’ we find a monthly time series labelled ‘Market-based leverage ratio (%)’. The average 2007 value for this series is 5.76%, and the latest value (that for November 2015) in that series is 5.28%. This series can be interpreted as the market-value estimate, as opposed to the book-value estimates referred to by my Bank correspondent.

The November 2015 value of 5.28% corresponds to a *fall* of 8.3% in the leverage ratio since 2007.

The two series we have therefore paint quite different pictures. Of the two, I would suggest that the market-based leverage ratio series is the better one, as it indicates how stock markets mark the book values of bank equity up or down in accordance with the information available to them.

Nonetheless, any interpretation of either of these two series as allowing us to compare banks’ leverage now with their leverage in 2007 is subject to a major caveat: even if the numerators and denominators are comparably defined (e.g., as being in

accordance with IFRS accounting standards, etc.), there have also been changes in the ways that IFRS has been implemented in the UK: in particular, in 2007, banks could (and did) have very poor quality assets without any requirement to disclose expected losses; however, this loophole has since been tightened up and the PRA now require banks to disclose (some) expected losses. Such changes make any comparison between 2007 and now problematic.

These reservations aside, there is evidence that banks’ leverage ratios have been improving. In a series of speeches over the last two years or so, Messrs Bailey, Carney and Co. suggested that UK banks now have somewhere between 7 and over 10 times as much core capital as they had before.[12] Given that banks’ assets or leverage exposures have clearly not increased by the same factor, then these capital figures would suggest that leverage ratios must have increased. They then jump to the conclusion that capital inadequacies have now been solved so lets move on: the long march to higher capital is over, the system has rebuilt its resilience and you can see this resilience in the stress tests.

Let me offer several observations about this narrative. First off, we can infer nothing useful about the banks’ capital positions from make-believe RWA-based metrics that produce fictitious capital ratios: these numbers belong in the bin for reasons I have explained multiple times elsewhere. This is one ginormous fly in the ointment.

Second, it is misleading to push the line that a tenfold-plus increase in banks’ capital levels implies some enormous capital rebuilding. In fact, banks’ capital levels were very low in the depth of 2008, and even a tenfold plus increase from a very low base does not translate into a large increase in banks’ actual capital levels. Nice try though.

Going further, I can play multipliers too: since banks’ losses were multiples of their reported capital levels,[13] then it must follow that banks’ capital levels in the depth of the crisis were not so much low as negative. To say that banks’ current capital levels are 10+ times (or 50 times or whatever times, makes little difference) their negative crisis levels then makes no sense at all and to quote capital-improvement ratios since then to suggest an enormous capital rebuilding is an offence against the Laws of Arithmetic.

As for the Bank of England’s claims about the UK banking system having rebuilt its resilience, I would simply ask: where is the evidence? The RWA-based numbers don’t count as evidence because they are fictitious, the evidence is not in the leverage ratio numbers because these are still very low, and any claims of resilience are further undermined by bank share price weakness: the stock markets do not believe the capital-rebuilding/resilience story either. And as for the stress tests demonstrating UK banks’ resilience, I can assure you that they demonstrate the opposite.[14]

Even the Wizard of Oz would have his work cut out creating financial resilience from these ingredients. But there is always hope and I leave the last word to Dorothy:

We're off to see the wizard, the wonderful Wizard of Oz.

We hear he is a whiz of a wiz if ever a wiz there was

If ever, oh, ever a wiz there was the Wizard of Oz is one because

Because, because, because, because, because

Because of the wonderful things he does.

### Conclusions

I conclude by restating my answers to my two questions and by offering a handful of comments:

**Question 1:** What is the latest available best estimate of the average leverage ratio across the UK banking system?

According to the data, the best estimate of UK banks’ latest average leverage ratio is about 3.66%.

But we should keep in mind the following:

- This leverage ratio is extremely low, relative to consensus expert opinion on what it should be for a safe and sound banking system. A widely held view among experts is that the minimum required leverage ratio should be
*at least*15%, with some experts arguing for much higher minimum required leverage ratios than even 15%.[15] - This estimate is biased upwards (a) because the numerator includes the ‘sin bucket’ of softer capital that ideally should not be included in the numerator and because of the possibility that retained earnings might be manipulated, and (b) because the denominator will be biased downwards because the Total Assets and Leverage Exposure measures ignore much of the banks’ off-balance-sheet risk.[16]. We cannot quantify the extent of this bias, but it is likely to be considerable.
- The reliability of all these figures is undermined by the weaknesses of IFRS accounting standards: the manipulability of retained earnings, inadequate reporting of expected losses, unreliable assumptions about mark-to-market valuations and netting effectiveness, and sundry other problems.

**Question 2:** How has the average leverage ratio across the UK banking system changed since 2007?

We cannot give a generally valid answer to this question that is robust across alternative choices of numerator and denominator in the leverage ratio. Of the two series available, the more reliable is the market-based simple leverage ratio, and according to this series, the average UK bank leverage ratio fell from 5.76% in 2007 to 5.28% by November 2015, i.e., it has fallen by 8.3% relative to its 2007 level.

However, neither series is fully satisfactory because of flaws in both numerator (e.g., the inclusion of soft capital instruments, including goodwill, DTAs etc.) and denominator (e.g., omission of major off-balance sheet risks) that serve to inflate banks’ measured leverage ratios, and hence overstate bank’s financial strength. Still, satisfactory or not, these are the only series we have spanning 2007 through 2015. And even with these series, any comparison between then and now is problematic due to changes in, e.g., the implementation of IFRS in the UK.

This said, putting the pieces of evidence together, we can conclude that there has been some modest rebuilding of UK banks’ capital positions. However, we should be wary of the Bank of England party line that banks’ capital has increased ten-fold: such hype disguises what is in reality a modest improvement and no more. It is therefore premature to conclude that the long march towards higher capital is over.

We are not yet in the Promised Land; we are not even close.

Personally, I doubt we will ever get there. At least the Israelites had a true prophet to guide them, and even he didn’t make it.

### Endnotes

[1] Kevin Dowd is Professor of Finance and Economics, Durham University Business School, Mill Hill Lane, Durham DH1 3LB, United Kingdom; email: kevin.dowd@durham.ac.uk. I thank Anat Admati, Tim Bush, Charles Goodhart, Martin Hutchinson, Gordon Kerr, Sir John Vickers, Basil Zafiriou and officials at the Bank of England for their helpful inputs to this article. Any remaining errors are my own.

[2] For solvency assessment purposes, the capital that matters is the hardest of hard capital, i.e., the fire resistant capital that can be deployed to support a bank in the heat of a crisis. Ideally this might be a measure as conservative as Common Tangible Equity (TCE), but consistent time series data on CTE are not available. Consequently, all the capital measures for which time series are available are polluted to a greater or lesser extent by the inclusion of softer capital instruments that may not be of any use in a solvency crisis. A good example of such instruments is DTAs. These allow a bank to claim back tax on previously incurred losses in the event that the bank subsequently returns to profitability. DTAs are useless in a crisis in which a bank’s solvency is at issue, but are still included in some measures of core capital. They shouldn’t be.

[3] For a more complete definition of CET1 capital, see Basel Committee on Banking Supervision (BCBS) “Basel III: A global regulatory framework for more resilient banks and banking systems” (Basel Committee, June 2011), p. 13.

[4] For more on this ‘sin bucket’, see “Basel III: A global regulatory framework for more resilient banks and banking systems” (Basel Committee, June 2011), pp. 21-6 and Annex 2; and Thomas F. Huertas *Safe to Fail: How resolution will revolutionise banking** *(Basingstoke: Palgrave Macmillan), 2014, p. 23.

[5] The LE measure was meant to include the off-balance-sheet (OBS) risks that the TA measure does not include. That it by and large fails to do so is obvious from the fact that the LE numbers are little different from the TA numbers. The failure of either measure to include much of a bank’s off-balance-sheet exposure means that the denominators of the leverage ratio are understated, potentially very much so.

[6] The financial institutions included here are those in Table 1, i.e., Barclays, HSBC, Lloyds, the Nationwide (which is a building society rather than a bank), RBS, Santander UK and Standard Chartered UK.

[7] According to the data in Annex 1 of the Bank of England’s 2015 stress test report, total CET1 across the big 7 banks was £243.7bn at the end of 2015Q3. As Table 1 shows, Total Assets across these banks at the same time was £5,546.7bn and the total Leverage Exposure across them was £5,635.1bn. The CET1 leverage ratio using the Total Assets denominator is therefore 243.7/5,546.7 = 4.39%, and the corresponding leverage ratio using the Leverage Exposure denominator is 243.7/5,635.7 = 4.32%.

[8] The number 0.84 comes from the Bank’s spreadsheet ‘ccbdec15.xlsx’ which is available here (accessed 25 March 2016). It is to be found on the spreadsheet ‘9. Equity measures’ under the B column.

[9] I am not suggesting that the market value estimate is by any means ‘perfect’ or even fully ‘efficient’ in the sense in which that term is used in the financial economics literature. Market history suggests that bank stock prices can gyrate excessively, and that at the peak of a crisis a bank’s market capitalisation can be excessively low. I am merely suggesting that the market value is more informative than the book value in the present context.

[10] For example, if we assume that banks make the maximum use of the sin bucket to inflate their CET1 capital figures, then we could say that 15% of the reported CET1 would consist of softer capital items. The ‘pure’ CET1 stripped of the sin bucket would then be 85% of the reported CET1, in which case the ‘true’ average CET1-based leverage ratio across the UK banking system would be under 85% times 3.66%, or under 3.11%.

[11] Sir John Vickers assures me in personal correspondence that that signature spells “Mervyn”. I couldn’t decrypt it myself but had gotten into my head that it spelt “Charlie” and I am happy to accept John’s correction. Its sure good to know that there is someone else out there with worse handwriting than mine.

[12] See, e.g., A. Bailey, “The capital adequacy of banks: today’s issues and what we have learned from the past,” speech given at Bloomberg, London, 10 July 2014, pp. 6-7; M. Carney, “The future of financial reform,” 2014 Monetary Authority of Singapore Lecture, 17 November 2014, p. 4; and M. Carney, “Redeeming an unforgiving world,” 8th Annual Institute of International Finance G20 Conference, Shanghai, 26 February 2016, p. 8.

[13] See, e.g., a study by the Local Authority Pension Fund Forum (2011, p. 3), which points out that over 2007-2010 UK banks’ losses were over 183% of their capital.

[14] See my forthcoming second edition of “No Stress - the flaws in the Bank of England’s stress testing programme”, to be published soon by the Adam Smith Institute.

[15] See A. Admati et alia, “Healthy banking system is the goal, not profitable banks”, *Financial Times* November 9, 2010. This letter was signed by no less than 20 distinguished financial economists. There are also other experts who have publicly said much the same thing, including Allan Meltzer, former BB&T CEO John Allison and *Bear’s Lair* author Martin Hutchinson. And yours truly.

[16] The key principles here are that when using leverage ratios for solvency assessment purposes not only should the numerator be as fireproof as possible, but the denominator should also express not the fair value of the bank’s positions (which is what the TA measure seeks to do) but should instead express its maximum plausible amount ‘at risk’. For example, loan guarantees, short CDS positions (also known as protection seller CDS positions) and short out-of-the-money option positions all have fair values that are well below the amounts of money that could be lost on them. Consequently, neither TA nor LE denominators do justice to the amounts at risk that the denominator should reflect.