Research Discussion Papers, Bank of Finland
No 10/2011:
Leverage ratio requirement, credit allocation and bank stability
Ilkka Kiema ()
and Esa Jokivuolle ()
Abstract: We study the effects on credit allocation and bank
stability of introducing a leverage ratio requirement (LRR) on top of
risk-based capital requirements, as in Basel III. For the current 3% LRR,
both low-risk and high-risk loan rates and volumes remain essentially
unchanged, because banks previously specializing in low-risk lending can
adapt by granting both low-risk and high-risk loans. For sufficiently high
LRRs, low-risk lending rates would significantly increase and high-risk
lending rates would fall. In the presence of severe ‘model risk’ concerning
low-risk loans, as happened in the subprime crisis, the current 3% LRR
might even reduce bank stability, counter to regulatory intentions. This is
because the allocational effect caused by the LRR, which makes bank loan
portfolios more alike, may turn beneficial risk spreading into harmful risk
contamination. For higher levels of LRR, however, bank stability is likely
to be improved even in the presence of model risk.
Keywords: bank regulation; Basel III; capital requirements; credit risk; leverage ratio; (follow links to similar papers)
JEL-Codes: D41; D82; G14; G21; G28; (follow links to similar papers)
53 pages, April 21, 2011
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