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FRM Part II · FRM Exam Part II · Capital Structure in Banks

A bank has Tier 1 capital of 40 billion and total exposure measure of 1,000 billion. Its risk-weighted assets are 400 billion. Which interpretation is most appropriate when comparing the Tier 1 leverage ratio to the Tier 1 risk-based ratio?

The leverage ratio is 4.0% (40/1,000) and the risk-based Tier 1 ratio is 10.0% (40/400). The difference reflects a low average risk weight of 40%. The non-risk-based leverage ratio serves as a backstop against underestimated risk weights.

  1. ALeverage ratio 4.0% and risk-based ratio 10.0%; the gap indicates low average risk weights, so the leverage ratio acts as a backstopCorrect
  2. BLeverage ratio 10.0% and risk-based ratio 4.0%; the bank is highly leveraged
  3. CBoth ratios equal 4.0%, so the measures are redundant
  4. DLeverage ratio 2.5% and risk-based ratio 10.0%; the bank fails the leverage minimum

Explanation

Leverage ratio = 40/1,000 = 4.0%; risk-based ratio = 40/400 = 10.0%. The average risk weight is 40% of exposure, so the risk-based ratio looks stronger. The non-risk-sensitive leverage ratio backstops possible risk-weight model understatement. Reversing the ratios swaps numerator bases.

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