The unintended consequences of the leverage ratio

The leverage ratio is one of the main innovations in the new banking regulatory framework, Basel III. It imposes a minimum amount of Tier 1 capital that depends on the size of the balance sheet, without any consideration for the riskiness of the assets. It complements the risk-based capital regulation that proved to be ineffective during the crisis—many banks had healthy capital ratios even though they were under severe stress. The minimum leverage ratio requirement under Basel III is 3% and might be supplemented with a GSIB leverage ratio surcharge.

But this requirement might have unintended consequences. In particular, low-profit but balance-sheet-intensive businesses, for which risk weights are very low, might become less profitable with the leverage ratio. The leverage ratio only applies at the consolidated group level, and thus it is not obvious why it should affect particular business activities if banks themselves are not constrained by this requirement. But there might be reasons: for instance, more complex institutions could find it easier to price different activities depending on which requirement binds in each case. In other words, banks might price high loan-to-value mortgages using the risk-based capital requirement, but price repo activities using the leverage ratio.

This can also apply to market-making activities, or banks acting as dealers: they might be less likely to hold the bonds on the balance sheet and hence less likely to provide liquidity. Some market participants, especially from the financial industry, claim that post-crisis regulation is behind the perceived reductions in market liquidity in the recent years, sometimes pointing at the leverage ratio as the main reason.

At the end of the day, however, this is an empirical question. It seems that dealers’ balance sheet utilisation has decreased, but for treasuries and corporate bonds at least, NYFed researchers do not find a reduction in market liquidity . Even if one observes a reduction in market liquidity, the key step is to link this reduction to the new banking regulation.

In an era of granular data and constant regulatory innovation (the perfect scenario to run tests), one would expect plenty of research currently looking at this issue. But we are not there yet. Nevertheless, the Office of Financial Research (OFR), which depends on the Department of the Treasury in the US, has recently published a working paper looking at how the leverage ratio is affecting tri-party repo activities. I will discuss the paper in the next post.

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One Response to The unintended consequences of the leverage ratio

  1. Pingback: Leverage ratio and repo activity | Francesc's Blog

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