The Leverage Ratio, Risk-Taking and Bank Stability

74 Pages Posted: 16 Nov 2018

See all articles by Jonathan Acosta Smith

Jonathan Acosta Smith

Bank of England

Michael Grill

European Central Bank (ECB)

Jan Hannes Lang

European Central Bank (ECB)

Multiple version iconThere are 2 versions of this paper

Date Written: November 9, 2018

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, 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 (November 9, 2018). Bank of England Working Paper No. 766. Available at SSRN: https://ssrn.com/abstract=3284435 or http://dx.doi.org/10.2139/ssrn.3284435

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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