How Can Leverage Regulations Work for the Stabilization of Financial Systems?

Abstract

The purpose of this paper is to analyze the leverage ratio requirement as currently considered by the Basel Committee on Banking Supervision from both theoretical and empirical perspectives. The key concept in this paper is the asset quality index, which is obtained by dividing the risk-based capital ratio by the gearing ratio (i.e., the inverse of the leverage ratio). Using this concept in the microeconomic framework, we can describe the behavior of banks as an optimal choice of a gearing ratio and an asset quality index. We derive theoretical implications from this model and compare them with the data on the G10 and Asian commercial banks. In so doing, we find that the leverage ratio requirement has a number of side effects, if introduced as a uniform international rule. In light of the theoretical and empirical results thus obtained, we discuss desirable uses of leverage ratios from the perspective of maintaining the stability of financial systems.