The Leverage Ratio, Risk-Taking and Bank Stability

74 Pages Posted: 21 Jun 2017  

Jonathan Acosta Smith

Bank of England

Michael Grill

European Central Bank (ECB)

Jan Hannes Lang

European Central Bank (ECB)

Date Written: June 20, 2017

Abstract

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

Suggested Citation

Acosta Smith, Jonathan and Grill, Michael and Lang, Jan Hannes, The Leverage Ratio, Risk-Taking and Bank Stability (June 20, 2017). ECB Working Paper No. 2079. Available at SSRN: https://ssrn.com/abstract=2990215

Jonathan Acosta Smith (Contact Author)

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

Michael Grill

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Jan Hannes Lang

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

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