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The leverage ratio, risk-taking and bank stability

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  • Acosta-Smith, Jonathan
  • Grill, Michael
  • Lang, Jan Hannes

Abstract

This paper analyses 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 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 leads to a significant decline in the distress probability of highly leveraged banks.

Suggested Citation

  • Acosta-Smith, Jonathan & Grill, Michael & Lang, Jan Hannes, 2024. "The leverage ratio, risk-taking and bank stability," Journal of Financial Stability, Elsevier, vol. 74(C).
  • Handle: RePEc:eee:finsta:v:74:y:2024:i:c:s1572308920301364
    DOI: 10.1016/j.jfs.2020.100833
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    More about this item

    Keywords

    Banking; Capital regulation; Risk-taking; Leverage ratio;
    All these keywords.

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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