Wize AP Macroeconomics Textbook > The Monetary System

Bank Capital and Leverage Ratio

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Bank Capital and Leverage Ratio
Bank capital - the resources a bank's owners have put into the institution 
Example:

Assets                          Liabilities
Reserves $200            Deposits $800    
Loans $700                  Debt $150
Securities $100            Capital (owners' equity) $50

Leverage - the use of borrowed money to supplement existing funds for purposes of investment 

Leverage ratio - the ratio of assets to bank capital

Leverage Ratio= Assets Bank Capital\boxed{\text{Leverage Ratio} =\ \frac{Assets}{\ Bank\ Capital}}Leverage Ratio=  Bank CapitalAssets​​

In the above example the leverage ratio = 1000/50 = 20

A leverage ratio of 20 means that for every dollar of capital that the bank owners have contributed, the bank has $20 of assets. This means of the $20 of assets, $19 are financed with borrowed money - either by taking in deposits or issuing debt.

In the example above, if the assets increase by 5% from $1000 to $1050, then the bank capital (owner's equity) would increase by 5% * 20 = 100%
 from $50 to $100
 . 

This shows that small percentage changes in assets can lead to big percentage changes in bank capital (owner's equity), which can be risky.

Capital Requirement - a government regulation specifying a minimum amount of bank capital 
 