Leverage ratio and risk-taking: theory and practice

The Prudential Regulation Authority, PRA, has published a new working paper titled „Leverage ratio and risk-taking: theory and practice“ in which it presents the findings from an analysis of the impact of leverage ratio requirements upon institutions‘ risk taking behavior and thus stability in the UK financial market. Minimum leverage ratio requirements which require a minimum fraction of Tier 1 capital (equity / retained earnings) as compared to banks‘ exposures (loans, financial instruments, including derivatives, etc.) were initially introduced by the Basel Committee on Banking Supervision (BCBS) within the Basel III framework following the financial crisis 2008/2009.
Specifically, the paper looked into institutions‘ behavior in terms of shifting more capital to riskier assets following the implementation of the leverage ratio requirements by the Basel framework. Since the leverage ratio does not differentiate between the riskiness of assets, banks can generally leverage their capital more effectively by investing in riskier assets. By doing so, they can achieve a higher return on equity, as they are not required to allocate as much capital to support these assets under the leverage ratio. This, in turn, can make their financial performance more favorable to shareholders and potentially improve their competitiveness.
The analysis presented in this paper revealed though that banks did NOT significantly switch over to riskier assets. In fact, their leverage levels even declined somewhat following the imposition of the new requirements, leading to lower aggregate levels of risks. As noted in the conclusion of the paper, this fact may at least be partially explained by the introduction of the risk-based capital requirements which require banks to hold more capital against riskier assets and less capital against safer assets and which would – naturally – offset the aim towards more riskier assets.