What is a bank's leverage ratio, and how does it differ from a risk-weighted capital ratio?

• A. Leverage ratio = tier 1 capital / total exposure; it is a simple, non-risk-weighted measure. The risk-weighted capital ratio uses risk-weighted assets to assess capital adequacy.
• B. Leverage ratio = total assets / total liabilities.
• C. Leverage ratio measures profitability.
• D. Leverage ratio is the same as risk-weighted ratio.

Answer: (A)

The question focuses on how banks measure capital relative to their activities in two different ways: a leverage-based view that ignores asset risk, and a risk-weighted view that accounts for riskiness.

The leverage ratio is calculated as Tier 1 capital divided by total exposure. “Total exposure” includes both on-balance-sheet assets and off-balance-sheet items, and it is not adjusted for risk. This makes the measure a simple backstop against excessive leverage, regardless of how risky the assets are.

The risk-weighted capital ratio, on the other hand, uses risk-weighted assets in the denominator. Assets are assigned weights based on their credit, market, and operational risk, so this ratio reflects how much capital is held relative to the riskiness of the bank’s assets.

So the statement that the leverage ratio uses Tier 1 capital over total exposure and is non-risk-weighted, while the risk-weighted ratio uses risk-weighted assets to assess capital adequacy, is the correct distinction.

The other descriptions don’t fit: the leverage ratio is not simply assets over liabilities, it is not a profitability measure, and it is not the same as the risk-weighted ratio.