One of the main reasons large financial institutions got into so much trouble during the Great Recession was because they took on so much debt, or leverage, that could not be seen on their balance sheets. For instance, the degree of leverage at Lehman Brothers, which ultimately collapsed, was supposedly 31 in 2007, meaning that for every $1 in equity, the company had $31 in debt. Because Lehman had such a small amount of cash set aside for losses or heavy outflows, any material impact to its assets or investments could make the firm insolvent, and that's exactly what happened.

Since then, regulators have created more methodologies to determine how much exposure and debt a bank has in order to ensure that what happened to Lehman Brothers doesn't happen again. As the economy heads into precarious times, it's a good idea to see where the large U.S. banks stand in terms of leverage.

Sign on an office saying Goldman Sachs

Image source: Goldman Sachs.

Supplementary leverage ratio

The supplementary leverage ratio (SLR) is one of the requirements bank regulators instituted following the Great Recession. Essentially, this ratio requires a big bank to hold 5% of liquid capital for its total leverage exposure. That way, if the banking system does experience an extremely stressed situation, or if people or institutions start taking their money out in large waves, banks have capital to cover losses.

Many bank investors focus on risk-based capital ratios, those that require banks to hold a certain amount of capital for assets based on their riskiness of not being repaid, or defaulting. But Sheila Bair and Thomas Hoenig, both former chairs of the Federal Deposit Insurance Corporation, argue that these aren't always the best measures of safety for banks during economic downturns.

"Risk-based ratios failed spectacularly in the lead up to the financial crisis as large banks took huge, highly leveraged stakes in securities and derivatives tied to mortgages because they and their regulators deemed those assets low risk," the two said in a recent Bloomberg op-ed. "After the crisis, global consensus emerged that regulators should backstop risk-based capital rules with leverage ratios, which proved to be more reliable indicators of solvency during the financial crisis."

The SLR is calculated by dividing Tier 1 capital, which mostly consists of retained earnings, common stock, and some types of preferred stock, by total leverage exposure. Leverage exposure is a complex calculation but includes exposure from assets on the balance sheet, derivatives, and other off-balance-sheet exposure. Below is where all the major U.S. banks stood with their supplementary leverage ratio at the end of the second quarter.

Bank Supplementary Leverage Ratio
JPMorgan Chase (JPM -0.67%) 6.8%
Bank of America (BAC -1.28%) 7%
Citigroup (C -1.58%) 6.7%
Wells Fargo (WFC -1.50%) N/A
Goldman Sachs (GS -0.40%) 6.7%
Morgan Stanley (MS -0.47%) 7.3%
Bank of New York Mellon (BK -1.48%) 8.2%
State Street (STT -2.25%) 8.3%

Data source: Company press releases.

As you can see above, all these banks were above the 5% requirement at the end of the second quarter (I didn't see one for Wells Fargo in the company's latest earnings report, but it had an SLR of 6.84% in Q1, which was good for that quarter). At 6.7%, Goldman Sachs and Citigroup had the lowest SLRs. 

Potential danger

In its annual stress testing in June, the Federal Reserve put all large banks with a presence in the U.S. through a set of hypothetical economic scenarios to see how their balance sheets would hold up during varying degrees of an economic downtown.

In one of the Fed's scenarios, called the severely adverse scenario, GDP would contract 8.5% from prerecession levels and unemployment would get as high as 10%, a scenario that is now not so hypothetical, given how the coronavirus pandemic has played out. In this scenario, some of the banks' SLRs get pretty low. JPMorgan's at one point hits 5.1%, Morgan Stanley 4.5%, and Goldman Sachs 3.5%.  

Additionally, the Fed ran more severe scenarios in its stress testing after its severely adverse scenario (above) turned out to be more of a reality because of the coronavirus. The Fed tested banks' balance sheets against a V-shaped economic recovery scenario, U-shaped recovery, and W-shaped recovery. While the Fed didn't provide as much disclosure about banks' performance in these scenarios, it did disclose the aggregate common equity Tier 1 (CET1) capital ratio results of all 33 banks tested.

The CET1 is a closely watched metric measuring a bank's core capital as a percentage of its risk-weighted assets. Banks saw their CET1 ratios depleted the most in a W-shaped scenario, which is categorized by unemployment peaking at 16% at some point over the next nine quarters and GDP contracting 12.4% from prerecession levels. In this scenario, the bottom quartile of banks posted an aggregate CET1 ratio of 4.8%. While we don't know whether JPMorgan, Morgan Stanley, and Goldman Sachs are included in this bottom quartile (although I suspect at least Goldman Sachs is) Bair and Hoenig in their op-ed note that "leverage ratios are typically less than half of banks' risk-based measures." That would bring the aggregate SLR of the bottom quartile of banks to somewhere around 2.4%, leaving a very small margin.

Keep in mind

Remember: In reality right now, all the banks are well above the 5% SLR minimum and in decent shape after already setting aside billions of dollars for potential loan losses. But the future is uncertain and economic conditions could deteriorate further. Although unlikely, if the Fed's scenarios representing a W-shaped economic scenario ever play out, JPMorgan, Morgan Stanley, and Goldman Sachs' cushion of capital to protect against leverage exposure could start to wear thin.