Leverage Ratio: Regulatory Impact On Business Models Should Be Taken Into Account

The leverage ratio is one of the most discussed regulatory topics. According to the Basel Committee on Banking Supervision (BSCB), a minimum level of 3% shall be obligatory from 2008 on. The Committee (2009, pp. 2-3) argues that a leverage ratio requirement “would help contain the build-up of excessive leverage in the banking system, introduce additional safeguards against attempts to game the risk-based requirements, and help address model risk“.

A recent study from Kiema and Jokivuolle on the question “Does a Leverage Ratio Requirement increase Bank Stability?” concludes that the impact the leverage ratio requirement (LRR) has on financial stability depends on its relative level compared to the average risk-based capital requirements:

  • LRR < average risk-based capital requirement: Banks are expected to adapt their business models to increase the mix of low-risk and high-risk loans in their portfolios. Today, as research suggests, “differences in banks’ general risk profiles are evident, indicating some degree of specialization (in low or high(er)-risk business models). For instance, the share of net loans to customers in relation to trading assets (often seen as riskier business) may vary greatly (for a sample of leading European banks, see Liikanen 2012, Table A3.2). There is also evidence that banks may focus on either corporate or retail loans, the former of which are normally seen as riskier.” Kiema and Jokivuolle also show that the diversification of the loan portfolio in low-risk and high-risk lending can lead to an increase of model risk.
  • LRR > average risk-based capital requirements: Bank failures are expected to decrease because more loss absorbing capital is available. This positive effect on bank stability is accompanied by a significant increase of low-risk lending rates as banks need to balance the higher cost of capital.

The study results indicate the following points: an increase of the leverage ratio requirement over and above 3% (1) might have a significant cost impact for low-risk banks because the LRR would require a higher capital buffer than the risk-based regulation and thus, (2) may require some banks to adjust the business model which will result in more risk-correlated bank portfolios, which (3) might increase model risk due to adjusted business models with similar portfolio risks. On the other hand, a higher LRR can (4) increase bank robustness and thus reduce model failure as more capital is available to absorb unexpected losses in case of stress. Also, a higher leverage ratio can (5) lead to higher low-risk lending rates impacting economic growth. Overall, Kiema and Jokivuolle argue “that a significant increase of the current 3% LRR recommendation, up to the point where the LRR matches the average bank’s risk-weighted capital requirement in the economy (more than 6% in our calibration), could have positive stability effects without compromising lending costs. This is because a higher LRR would simply provide a more sufficient buffer against even very big model risk while banks could (almost) costlessly adjust to it by changing their loan portfolios. As the lower LRR would in any case result in much of the portfolio adjustment, it is better to let this happen with the higher LRR, with higher stability gains.”

With respect to K/J’s policy implications, we want to note that further research should be made before implementing binding rules in Europe, because:

  • the dependence on other Basel proposals such as the fundamental review of the trading book or the new design of the credit risk framework should be carefully studied;
  • the role of different bank business models for the respective national banking system should not be neglected by a one-size-fits-all approach;
  • expected adjustments in business models should be analysed concerning the new IFRS9 impairment rules to better understand the impact on risk-based capital requirements;
  • differences in financial systems such as the size of the securitisation market should be taken into account and addressed first, to ensure a competitive European financial system.

Finally, it is worth looking at the US regulators. They adopted a final minimum level of 5% in April 2014. This additional 2%-rule applies to US top-tier banks only. In addition, the US regulators aim to adapt the calculation of the US leverage ratio to the Basel recommendation, which is the basis for the European leverage ratio.

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