Bank Leverage and Capital Bias Adjustment Through the Macroeconomic Cycle

Abstract

We assess the quantitative effects of the recent proposal for more robust bank capital adequacy. Our theoretical proof and evidence accord with the core thesis that banks become more stable by increasing their equity capital cushion to absorb extreme losses in times of severe financial stress. This analysis contributes to the ongoing policy debate on total capital adequacy. Our Monte Carlo simulation helps develop an analytical solution for the default probability adjustment through the macroeconomic cycle. This study poses a conceptual challenge to the normative view that banks should maintain high leverage over time.

Keywords: bank capital, leverage, macroeconomic cycle, default probability, Monte Carlo simulation, Basel capital accord

JEL Classification: G01, G18, G21, G32