The leverage ratio requires banks to hold capital in proportion to the overall size of their balance sheet. As opposed to the capital ratio, risk-weights are irrelevant to its calculation. The leverage ratio therefore makes it relatively more costly for banks to engage in low margin activities. One such activity – which is crucial to the transmission of monetary policy and financial stability – is repo. This column shows that a tightening of the leverage ratio resulting from a change in reporting requirements incentivised UK dealers to reduce their repo activity, especially affecting small banks and non-bank financial institutions. The UK gilt repo market, however, showed resilience with foreign, non-constrained dealers quickly stepping in.
A key feature of the post-crisis regulatory reform agenda has been the introduction of a leverage ratio to complement the risk-weighted framework. The FPC designed the UK leverage ratio to mirror risk-weighted capital requirements so the two frameworks move in lock-step over time and across firms. For the sake of simplicity however, the FPC did not reflect Pillar 2 capital charges, which aim to capture risks that cannot be modelled adequately in the risk-weighted framework, in the leverage ratio framework. In this post we explore what happens to leverage and risk-weighted requirements once Pillar 2 are taken into account. We find that in keeping the leverage ratio simple, the perfect lock-step interaction with risk-weighted requirements no longer holds, which could prompt riskier banks to take on more risk.
When banks are subject to both a leverage and a risk-weighted constraint they may violate a fundamental law of economics: that of demand. In our theoretical model, some banks constrained by the leverage ratio react to an increase in capital requirements by investing more in the asset. This so-called ‘Giffen’ behaviour is very counterintuitive. One would assume the opposite to be the case: higher capital requirements should discourage lending. In our theoretical model, Giffen behaviour is likely to occur for firms that hold predominantly low-risk weighted asset and are therefore bound by the leverage ratio. The real-world equivalent in the context of mortgages would be building societies and, in the future, ring-fenced banks. Continue reading “Are mortgages like potatoes? Unintended consequences in a world of many constraints”→