Taking a long hard look in the mirror: should the leverage ratio reflect Pillar 2?

Mounir Kenaissi and Mariana Gimpelewicz.

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.

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Unintended consequences: specialising in risky mortgages under Basel II

Matteo Benetton, Peter Eckley, Nicola Garbarino, Liam Kirwin and Georgia Latsi.

Do financial regulations change bank behaviour? Does this create new risks? Under Basel II, some banks set capital requirements based on their internal risk models; others use an off-the-shelf standardised approach. These two methodologies can produce very different capital requirements for similar assets. See Figure 1, which displays a snapshot of recent risk weights for UK mortgages. In a new working paper we show empirically that this discrepancy causes lenders to adjust their interest rates and to specialise in which borrowers they target.

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