The Leverage Ratio, Risk-Taking and Bank Stability
74 Pages Posted: 21 Jun 2017
Date Written: June 20, 2017
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 and therefore increased loss-absorbing capacity, 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.
Keywords: Bank Capital, Risk-Taking, Leverage Ratio, Basel III
JEL Classification: G01, G21, G28
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