The global financial crisis has highlighted the limitations of risk-sensitive bank capital ratios. To tackle this problem, the Basel III regulatory framework has introduced a minimum leverage ratio, defined as a banks Tier 1 capital over an exposure measure, which is independent of risk assessment. Using a medium sized DSGE model that features a banking sector, financial frictions and various economic agents with differing degrees of creditworthiness, we seek to answer three questions:
- How does the leverage ratio behave over the cycle compared with the risk-weighted asset ratio?
- What are the costs and the benefits of introducing a leverage ratio, in terms of the levels and volatilities of some key macro variables of interest?
- What can we learn about the interaction of the two regulatory ratios in the long run?
The main answers are the following:
- The leverage ratio acts as a backstop to the risk-sensitive capital requirement: it is a tight constraint during a boom and a soft constraint in a bust;
- the net benefits of introducing the leverage ratio could be substantial;
- the steady state value of the regulatory minima for the two ratios strongly depends on the riskiness and the composition of bank lending portfolios.