ECB Says ‘Modest’ Leverage Limitations Add to Banks Stability

  • Ratio leads to more risk-taking but higher loss-absorption
  • Leverage ratio's positive effect fades when set too high

European banks will become more stable with the introduction of limits on leverage if the levels aren’t set too high, research by the European Central Bank showed.

A leverage ratio, which isn’t weighted for risk, and existing risk-weighted capital requirements will complement each other, making the banking system more reliable, according to a study published Monday as part of the ECB’s Financial Stability Report. The benefit starts to fade when the leverage ratio reaches about 5 percent, authors Michael Grill, Jan Hannes Lang and Jonathan Smith wrote.

Global regulators added a cap on how much debt banks can take on relative to their assets after the 2008 financial crisis. The Basel Committee on Banking Supervision is testing a non-binding leverage ratio of 3 percent of assets, which is expected to be re-calibrated and turned into a binding requirement by 2018.

The rationale for introducing a leverage ratio is that risk weights appeared to be unreliable or even manipulated in the crisis, leaving banks with insufficient capital in distress. However, policy makers including Sweden’s Finansinspektionen financial regulator have warned that risk-insensitive capital requirements could lead to a less stable system.

“Increasing the LR from low levels seems to be of considerable benefit to bank stability, but as a bank’s LR reaches around 5 percent, the benefits of increasing it further start to diminish slightly,” the researchers write. “There may be considerable benefit in introducing the LR requirement with a modest calibration.”

The ECB studied the impact of adding the leverage ratio to the risk-weighted capital requirements both in a theoretical model and based on financial data for 500 banks in the European Union from 2005 to 2014. 

The model shows that while banks have an incentive to take on slightly riskier assets, that is more than offset by the additional capital banks have to raise to meet the ratio.

A 1 percentage-point increase in a bank’s leverage ratio reduces the probability of distress by 35 percent to 39 percent, according to the study. By contrast, the same increase in risk-weighted assets, increases the risk by 1 percent to 3.5 percent.

“The LR and the risk-based capital framework are mutually reinforcing as they each cover risks which the other is less able to capture; ensuring banks do not operate with excessive leverage and, at the same time, have sufficient incentives to keep risk-taking in check,” the researchers wrote.

Before it's here, it's on the Bloomberg Terminal.