The Leverage Ratio, Risk-Taking and Bank Stability

Under the new Basel III banking regulations, a non-risk based leverage ratio will be introduced alongside the risk-based capital requirement. This move away from a solely risk-based capital framework has raised some concern of increased bank risk-taking; potentially offsetting any benefits from requiring highly leveraged banks to hold more capital. We address exactly this tradeoff between additional loss-absorbing capacity and higher bank risk-taking associated with a leverage ratio requirement in both a theoretical and empirical setting. Using a theoretical micro model, we show that a leverage ratio requirement can indeed incentivise bound banks to slightly increase their risktaking, but this increase in risk-taking should be more than outweighed by the increase in loss-absorbing capacity from higher capital, thus leading to more stable banks. These theoretical predictions are then tested and confirmed in an empirical analysis on a large sample of EU banks. Our baseline empirical model suggests that a leverage ratio requirement would lead to a significant decline in the failure probability of highly leveraged banks. ∗Contact: Michael Grill, European Central Bank, [email protected]; Jan Hannes Lang, European Central Bank, [email protected]; Jonathan Smith, University of Cambridge, [email protected]. We would like to thank Sylvain Benoit, Petra Geraats, Mike Mariathasan, Barbara Meller, Alexander Popov, Gabriel Jimenez and Nicolas-Kirti Scholtes for their comments and useful discussions. We are also grateful to participants at the 4th EBA Policy Research Workshop, the ECB 2nd Workshop of the Empirical Macro Workstream of the OMR Task Force, PTLR meetings at the Bank of Portugal and EBA, the 5th Paris EconomiX PhD Student Conference in International Macroeconomics and Financial Econometrics, the 2016 Scottish Economic Society Annual Conference, the Belgian Financial Research Forum and at seminars held at the European Central Bank, University of Cambridge, Bank of England, Riksbank and Bank of Mexico. Disclaimer: The views expressed in this paper are those of the authors and do not necessarily reflect those of the European Central Bank or the Eurosystem. All results are derived from publicly available information and do not imply any policy conclusions regarding individual banks.