The leverage ratio, risk-taking and bank stability

Staff working papers set out research in progress by our staff, with the aim of encouraging comments and debate.
Published on 09 November 2018

Staff Working Paper No. 766

By Jonathan Acosta-Smith, Michael Grill and Jan Hannes Lang

This paper addresses the trade-off between additional loss-absorbing capacity and potentially higher bank risk-taking associated with the introduction of the Basel III leverage ratio. This is addressed in both a theoretical and empirical setting. Using a theoretical micro model, we show that a leverage ratio requirement can incentivise banks that are bound by it to increase their risk-taking. This increase in risk-taking however, should be more than outweighed by the benefits of higher capital, thereby leading to more stable banks. These theoretical predictions are 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 distress probability of highly leveraged banks.

PDFThe leverage ratio, risk-taking and bank stability

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