Bank Leverage Limits and Regulatory Arbitrage: New Evidence on a Recurring Question

41 Pages Posted: 20 Jun 2018 Last revised: 8 Nov 2018

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

Bankers are regulated more than most business owners, giving them more incentive to arbitrage (avoid) regulation via loopholes. The supplementary leverage ratio (SLR) rule may present their latest arbitrage opportunity. Enacted after the crisis to prevent another leverage buildup, the rule caps leverage at the very largest U.S. banks. While the leverage rule is simpler than risk-based capital requirements because it requires equal capital against assets with unequal risk, bankers can arbitrage by shedding safer assets and/or adding riskier ones. An earlier leverage rule imposed in 1981 invited the same arbitrage, but there is little or no evidence that bankers exploited it. We find more compelling evidence of leverage rule arbitrage around the new rule. Studying difference-in-differences, we find higher risk (risk-weighted) asset shares and security yields at SLR banks relative to the control (the next largest set of banks) after the SLR was finalized in 2014. The effects tend to be larger at more leverage-rule-constrained banks, and some are substantial; mean yields at SLR banks rose (relatively) about 30 basis points. While this arbitrage might have, perversely, increased overall bank risk, we find no evidence that it did. Book and market risk measures were all essentially unchanged except one: leverage. The most constrained SLR banks significantly de-levered, commencing precisely when public disclosure of leverage ratios was required. Their reduced leverage may have offset the asset arbitrage, leaving overall risk unchanged.

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: New Evidence on a Recurring Question (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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