June 20, 2017

ECB published a working paper that 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, the authors show that a leverage ratio requirement can offer incentives to banks that are bound by it to increase their risk-taking. However, this increase in risk-taking should be more than outweighed by the benefits of higher capital and therefore increased loss-absorbing capacity, thus leading to more stable banks. The analysis performed by the authors further suggests that the leverage ratio and the risk-based capital framework reinforce each other by covering risks which the other is less able to capture, thus making sure that banks do not operate with excessive leverage and have sufficient incentives to keep risk-taking in check. The analysis therefore supports the introduction of a leverage ratio, alongside the risk-based capital framework. These theoretical predictions are tested and confirmed in an empirical analysis on a large sample of EU banks. The baseline empirical model suggests that a leverage ratio requirement would lead to a significant decline in the distress probability of highly leveraged banks.

 

Related Link: Working Paper (PDF)

Keywords: Europe, ECB, Banking, Leverage Ratio, Basel III, Loss Absorbency

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