Does a leverage ratio requirement increase bank stability?

Arbeitspapier

Basel III has introduced a non-risk-weighted leverage ratio requirement (LRR) which complements the internal ratings based (IRB) capital requirements. It provides a backstop against model risk which arises if some loans get incorrectly rated and become toxic. We study the effects of the LRR on lending strategies and its implications for banks’ stability. We show that the LRR might induce banks with low-risk lending strategies to diversify their portfolios into high-risk loans until the LRR is no longer the binding capital constraint on them. If the LRR is lower than the average bank’s IRB requirement, the aggregate capital costs of banks do not increase. However, because the diversification makes banks’ portfolios more alike the banking sector as a whole may become more exposed to model risk in each loan category. This may undermine banking sec- tor stability. On balance, our calibrated model motivates a significantly higher LRR than the current one.

Object Details

• Language: Englisch

References and Relationships

• Bibliographic citation: Series: ECB Working Paper ; No. 1676

Classification and Topics

• Classification: Wirtschaft ; Market Structure, Pricing, and Design: Perfect Competition ; Asymmetric and Private Information; Mechanism Design ; Information and Market Efficiency; Event Studies; Insider Trading ; Banks; Depository Institutions; Micro Finance Institutions; Mortgages ; Financial Institutions and Services: Government Policy and Regulation
• Subject: bank regulation ; Basel III ; capital requirements ; credit risk ; leverage ratio

Contributors, Places and Time

• Event: Geistige Schöpfung
• (who): Kiema, Ilkka ; Jokivuolle, Esa
• Event: Veröffentlichung
• (who): European Central Bank (ECB)
• (where): Frankfurt a. M.
• (when): 2014

Further information

• Handle: http://hdl.handle.net/10419/154109
• Last update: 10.03.2025, 11:45 AM CET