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Regulatory Constraints on Bank Leverage: Issues and Lessons from the Canadian Experience

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  • Etienne Bordeleau
  • Allan Crawford
  • Christopher Graham
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    Abstract

    The Basel capital framework plays an important role in risk management by linking a bank's minimum capital requirements to the riskiness of its assets. Nevertheless, the risk estimates underlying these calculations may be imperfect, and it appears that a cyclical bias in measures of risk-adjusted capital contributed to procyclical increases in global leverage prior to the recent financial crisis. As such, international policy discussions are considering an unweighted leverage ratio as a supplement to existing risk-weighted capital requirements. Canadian banks offer a useful case study in this respect, having been subject to a regulatory ceiling on an unweighted leverage ratio since the early 1980s. The authors review lessons from the Canadian experience with leverage constraints, and provide some empirical analysis on how such constraints affect banks' leverage management. In contrast to a number of countries without regulatory constraints, leverage at major Canadian banks was relatively stable leading up to the crisis, reducing pressure for deleveraging during the economic downturn. Empirical results suggest that major Canadian banks follow different strategies for managing their leverage. Some banks tend to raise their precautionary buffer quickly, through sharp reductions in asset growth and faster capital growth, when a shock pushes leverage too close to its authorized limit. For other banks, shocks have more persistent effects on leverage, possibly because these banks tend to have higher buffers on average. Overall, the authors' results suggest that a leverage ceiling would be a useful tool to complement risk-weighted measures and mitigate procyclical tendencies in the financial system.

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    File URL: http://www.bankofcanada.ca/en/res/dp/2009/dp09-15.pdf
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    Bibliographic Info

    Paper provided by Bank of Canada in its series Discussion Papers with number 09-15.

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    Length: 26 pages
    Date of creation: 2009
    Date of revision:
    Handle: RePEc:bca:bocadp:09-15

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    Keywords: Financial institutions; Financial stability; Financial system regulation and policies;

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    References

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    1. Elijah Brewer, III & George G. Kaufman & Larry D. Wall, 2008. "Bank capital ratios across countries: why do they vary?," Working Paper 2008-27, Federal Reserve Bank of Atlanta.
    2. Wall, Larry D. & Peterson, David R., 1987. "The effect of capital adequacy guidelines on large bank holding companies," Journal of Banking & Finance, Elsevier, vol. 11(4), pages 581-600, December.
    3. Jacob A. Bikker & Paul A. J. Metzemakers, 2007. "Is Bank Capital Procyclical? A Cross-Country Analysis," Credit and Capital Markets, Credit and Capital Markets, vol. 40(2), pages 225-264.
    4. Ayuso, Juan & Perez, Daniel & Saurina, Jesus, 2004. "Are capital buffers pro-cyclical?: Evidence from Spanish panel data," Journal of Financial Intermediation, Elsevier, vol. 13(2), pages 249-264, April.
    5. Xiujian Chen & Shu Lin & W. Robert Reed, 2006. "Another Look at what to do with Time-series Cross-section Data," Working Papers in Economics 06/04, University of Canterbury, Department of Economics and Finance.
    6. Hansen, B.E., 1991. "Inference when a Nuisance Parameter is Not Identified Under the Null Hypothesis," RCER Working Papers 296, University of Rochester - Center for Economic Research (RCER).
    7. Andrews, Donald W K, 1993. "Tests for Parameter Instability and Structural Change with Unknown Change Point," Econometrica, Econometric Society, vol. 61(4), pages 821-56, July.
    8. Jokipii, Terhi & Milne, Alistair, 2007. "The Cyclical Behaviour of European Bank Capital Buffers," SIFR Research Report Series 56, Institute for Financial Research.
    9. Mark Illing & Graydon Paulin, 2004. "The New Basel Capital Accord and the Cyclical Behaviour of Bank Capital," Working Papers 04-30, Bank of Canada.
    10. Rime, Bertrand, 2001. "Capital requirements and bank behaviour: Empirical evidence for Switzerland," Journal of Banking & Finance, Elsevier, vol. 25(4), pages 789-805, April.
    11. Blum, Jürg M., 2008. "Why 'Basel II' may need a leverage ratio restriction," Journal of Banking & Finance, Elsevier, vol. 32(8), pages 1699-1707, August.
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    Cited by:
    1. H. Evren Damar & Césaire A. Meh & Yaz Terajima, 2010. "Leverage, Balance Sheet Size and Wholesale Funding," Working Papers 10-39, Bank of Canada.
    2. Guidara, Alaa & Lai, Van Son & Soumaré, Issouf & Tchana, Fulbert Tchana, 2013. "Banks’ capital buffer, risk and performance in the Canadian banking system: Impact of business cycles and regulatory changes," Journal of Banking & Finance, Elsevier, vol. 37(9), pages 3373-3387.
    3. Bouvatier, Vincent & López-Villavicencio, Antonia & Mignon, Valérie, 2014. "Short-run dynamics in bank credit: Assessing nonlinearities in cyclicality," Economic Modelling, Elsevier, vol. 37(C), pages 127-136.

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