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Leverage ratio requirement, credit allocation and bank stability

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  • Kiema , Ilkka

    ()
    (University of Helsinki, Department of Political and Economic Studies)

  • Jokivuolle, Esa

    ()
    (Aalto University School of Economics, Department of Finance and Bank of Finland, Monetary Policy and Research)

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    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.

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    File URL: http://www.suomenpankki.fi/en/julkaisut/tutkimukset/keskustelualoitteet/Documents/BoF_DP_1110.pdf
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    Bibliographic Info

    Paper provided by Bank of Finland in its series Research Discussion Papers with number 10/2011.

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    Length: 53 pages
    Date of creation: 21 Apr 2011
    Date of revision:
    Handle: RePEc:hhs:bofrdp:2011_010

    Contact details of provider:
    Postal: Bank of Finland, P.O. Box 160, FI-00101 Helsinki, Finland
    Web page: http://www.suomenpankki.fi/en/
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    Related research

    Keywords: bank regulation; Basel III; capital requirements; credit risk; leverage ratio;

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    Cited by:
    1. Heinrich, Gregor, 2011. "Basilea III y la relevancia para la banca de desarrollo en América Latina
      [Basel III and the relevance for development banks in Latin America]
      ," MPRA Paper 47401, University Library of Munich, Germany.
    2. Riccetti, Luca & Russo, Alberto & Mauro, Gallegati, 2013. "Financial Regulation in an Agent Based Macroeconomic Model," MPRA Paper 51013, University Library of Munich, Germany.

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