Leverage and Risk Weighted Capital Requirements

38 Pages Posted: 11 Oct 2016

See all articles by Leonardo Gambacorta

Leonardo Gambacorta

Bank for International Settlements (BIS); Centre for Economic Policy Research (CEPR)

Sudipto Karmakar

Bank of England

Multiple version iconThere are 2 versions of this paper

Date Written: September 2016

Abstract

The global financial crisis has highlighted the limitations of risk-sensitive bank capital ratios. To tackle this problem, the Basel III regulatory framework has introduced a minimum leverage ratio, defined as a banks Tier 1 capital over an exposure measure, which is independent of risk assessment. Using a medium sized DSGE model that features a banking sector, financial frictions and various economic agents with differing degrees of creditworthiness, we seek to answer three questions: 1) How does the leverage ratio behave over the cycle compared with the risk-weighted asset ratio? 2) What are the costs and the benefits of introducing a leverage ratio, in terms of the levels and volatilities of some key macro variables of interest? 3) What can we learn about the interaction of the two regulatory ratios in the long run? The main answers are the following: 1) The leverage ratio acts as a backstop to the risk-sensitive capital requirement: it is a tight constraint during a boom and a soft constraint in a bust; 2) the net benefits of introducing the leverage ratio could be substantial; 3) the steady state value of the regulatory minima for the two ratios strongly depends on the riskiness and the composition of bank lending portfolios.

Keywords: bank capital buffers, regulation, risk-weighted assets, leverage

JEL Classification: G21, G28, G32

Suggested Citation

Gambacorta, Leonardo and Karmakar, Sudipto, Leverage and Risk Weighted Capital Requirements (September 2016). BIS Working Paper No. 586, Available at SSRN: https://ssrn.com/abstract=2849574

Leonardo Gambacorta (Contact Author)

Bank for International Settlements (BIS) ( email )

Centralbahnplatz 2
Basel, Basel-Stadt 4002
Switzerland

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Sudipto Karmakar

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

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