Procyclicality and Bank Portfolio Risk Level Under A Constant Leverage Ratio

We investigate the impact the risk sensitive regulatory ratio may have on banks' risk taking behaviours during the business cycle. We show that the risk sensitivity of capital requirements introduce by Basel II adds either an "equity surplus" or an "equity deficit" on a bank that owns a fixed capital endowment and a constant leverage ratio. Depending on the magnitude of cyclical variations into requirements, the "surplus" may be exploited by the bank to increase its value toward the selection of a riskier asset or the "deficit" may restrict the bank to opt for a less risky asset. Whether the optimal asset risk level swings among classes of risk through the cycle, the risk level of bank's portfolio may increase during economic upturns, or decrease in downturns, leading to a rise in financial fragility or a "fly to quality" phenomenon.