Bank Leverage Limits and Regulatory Arbitrage: Old Question, New Evidence

43 Pages Posted: 20 Jun 2018 Last revised: 28 Dec 2019

See all articles by Dong Beom Choi

Dong Beom Choi

Seoul National University - Business School

Michael R. Holcomb

Federal Reserve Banks - Federal Reserve Bank of New York

Donald P. Morgan

Federal Reserve Bank of New York

Date Written: June 1, 2018

Abstract

Banks are regulated more than most firms, making them good subjects to study regulatory arbitrage (avoidance). Their latest arbitrage opportunity may be the new leverage rule covering the largest U.S. banks; leverage rules require equal capital against assets with unequal risks, so banks can effectively relax the leverage constraint by increasing asset risk. Consistent with that conjecture, we find that banks covered by the new rule shifted to riskier, higher yielding securities relative to control banks. The shift began almost precisely when the rule was finalized in 2014, well before it took effect in 2018. Security-level analysis suggests banks actively added riskier securities, rather than merely shedding safer ones. Despite the risk-shifting, overall bank risk did not increase, evidently because the banks most constrained by the new leverage rule significantly increased leverage capital ratios.

Keywords: Basel III regulation, bank risk, leverage limit, regulatory arbitrage, reaching for yield

JEL Classification: G20, G21, G28

Suggested Citation

Choi, Dong Beom and Holcomb, Michael R. and Morgan, Donald P., Bank Leverage Limits and Regulatory Arbitrage: Old Question, New Evidence (June 1, 2018). FRB of New York Staff Report No. 856, Available at SSRN: https://ssrn.com/abstract=3199997 or http://dx.doi.org/10.2139/ssrn.3199997

Dong Beom Choi

Seoul National University - Business School ( email )

Seoul
Korea, Republic of (South Korea)

Michael R. Holcomb

Federal Reserve Banks - Federal Reserve Bank of New York ( email )

33 Liberty Street
New York, NY 10045
United States

Donald P. Morgan (Contact Author)

Federal Reserve Bank of New York ( email )

33 Liberty Street
Research Department
New York, NY 10045
United States
212-720-6573 (Phone)

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