The Role of the Leverage Ratio in Capital Regulation of the Banking Sector

Basel III responded to the financial crisis by redefining and expanding the capital requirements for risk-weighted assets and by proposing the introduction of a leverage ratio setting a minimum level of capital for banks in relation to total exposures. The capital requirement is being increased primarily through the active use of macroprudential capital buffers. As a result, there have been proposals that the leverage ratio requirement should also take into account the level of capital buffers and thus become a macroprudential policy tool. One argument in support of such proposals is that if the level of capital buffers is not taken into account, the leverage ratio may not create a sufficient constraint on the size of banks' exposures and hence not fulfil its intended purpose. This article examines the relationship between the capital and leverage ratios and discusses the options for, and effects of, introducing a macroprudential leverage ratio. We find that the capital and leverage ratios complement each other and that the introduction of a macroprudential leverage ratio could, under certain circumstances, enhance the effectiveness of macroprudential policy.