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Leverage and Risk-Weighted Capital Requirements

Author

Listed:
  • Leonardo Gambacorta

    (Bank for International Settlements and CEPR)

  • Sudipto Karmakar

    (Bank of Portugal, UECE, and REM)

Abstract

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 bank's 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: (i) How does the leverage ratio behave over the cycle compared with the risk-weighted asset ratio? (ii) 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? (iii) What can we learn about the interaction of the two regulatory ratios in the long run? The main answers are the following: (i) 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; (ii) the net benefits of introducing the leverage ratio could be substantial; (iii) the steady-state value of the regulatory minimums for the two ratios strongly depends on the riskiness and the composition of bank lending portfolios.

Suggested Citation

  • Leonardo Gambacorta & Sudipto Karmakar, 2018. "Leverage and Risk-Weighted Capital Requirements," International Journal of Central Banking, International Journal of Central Banking, vol. 14(5), pages 153-191, December.
    • Handle: RePEc:ijc:ijcjou:y:2018:q:4:a:4
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    Cited by:

    1. Giuseppe Mastromatteo & Lorenzo Esposito, 2023. "Can It Be Prevented This Time?: The Role of Profits in Banking Regulation," Economics Working Paper Archive wp_1021, Levy Economics Institute.
    2. Müller, Carola, 2022. "Capital requirements, market structure, and heterogeneous banks," IWH Discussion Papers 15/2022, Halle Institute for Economic Research (IWH).
    3. Kirstin Hubrich & Daniel F. Waggoner, 2022. "The Transmission of Financial Shocks and Leverage of Financial Institutions: An Endogenous Regime-Switching Framework," FRB Atlanta Working Paper 2022-5, Federal Reserve Bank of Atlanta.
    4. Oscar Valencia & Daniel Osorio & Pablo Garay, 2017. "The role of capital requirements and credit composition in the transmission of macroeconomic and financial shocks," Revista ESPE - Ensayos Sobre Política Económica, Banco de la República, vol. 35(84), pages 203-221.
    5. Ghulame Rubbaniy & Ali Awais Khalid & Stathis Polyzos & Balqees Naser Almessabi, 2022. "Cyclicality of capital adequacy ratios in heterogeneous environment: A nonlinear panel smooth transition regression explanation," Managerial and Decision Economics, John Wiley & Sons, Ltd., vol. 43(6), pages 1960-1979, September.
    6. repec:ptu:bdpart:e201712 is not listed on IDEAS
    7. Ioana Neamtu & Quynh-Anh Vo, 2021. "Capital allocation, the leverage ratio requirement," Bank of England working papers 956, Bank of England.
    8. Jens Fittje, 2023. "Risk-shifting, concentration risk, and heterogeneous borrowers," International Economics and Economic Policy, Springer, vol. 20(4), pages 509-536, October.
    9. repec:ptu:bdpart:r201712 is not listed on IDEAS
    10. Dina Baptista & Sudipto Karmakar, 2017. "Understanding the Basel III Leverage Ratio Requirement," Economic Bulletin and Financial Stability Report Articles and Banco de Portugal Economic Studies, Banco de Portugal, Economics and Research Department.
    11. Garcia Revelo, Jose D. & Levieuge, Grégory, 2022. "When could Macroprudential and Monetary Policies be in Conflict?," Journal of Banking & Finance, Elsevier, vol. 139(C).
    12. Müller, Carola, 2018. "Basel III capital requirements and heterogeneous banks," IWH Discussion Papers 14/2018, Halle Institute for Economic Research (IWH), revised 2018.
    13. Glocker, Christian, 2019. "Do reserve requirements reduce the risk of bank failure?," MPRA Paper 95634, University Library of Munich, Germany.
    14. Jakubik, Petr & Moinescu, Bogdan Gabriel, 2025. "Tailored microprudential recommendations for bank profit retention using a risk tolerance framework," International Review of Economics & Finance, Elsevier, vol. 98(C).
    15. Robert-Paul Berben & Ide Kearney & Robert Vermeulen, 2018. "DELFI 2.0, DNB's Macroeconomic Policy Model of the Netherlands," DNB Occasional Studies 1605, Netherlands Central Bank, Research Department.
    16. Cantrell, Brett W. & Yust, Christopher G., 2018. "The relation between religiosity and private bank outcomes," Journal of Banking & Finance, Elsevier, vol. 91(C), pages 86-105.
    17. Jude, Cristina & Levieuge, Grégory, 2025. "Doubling down: The synergy of CCyB release and monetary policy easing," Journal of International Money and Finance, Elsevier, vol. 155(C).
    18. John R. Walter, 2019. "US Bank Capital Regulation: History and Changes Since the Financial Crisis," Economic Quarterly, Federal Reserve Bank of Richmond, issue 1Q, pages 1-40.
    19. Lorenzo Esposito & Giuseppe Mastromatteo, 2020. "Profitti, rischi e capital ratios: come sviluppare una vigilanza prudenziale neutrale al risk-appetite delle banche (Profits, risk, and capital ratios: how to design a prudential supervision neutral with respect to banks? risk appetite)," Moneta e Credito, Economia civile, vol. 73(290), pages 141-154.
    20. Kristina Bluwstein & Julieta Yung, 2019. "Back to the real economy: the effects of risk perception shocks on the term premium and bank lending," Bank of England working papers 806, Bank of England.

    More about this item

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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