Leverage ratio: Micro evidence of the backstop function to risk-based capital requirements
Authors: Florian Balke (Goethe University)
Title: Leverage ratio: Micro evidence of the backstop function to risk-based capital requirements
Abstract: The build-up of excessive on- and off-balance sheet leverage in the banking system is wide-spread recognized as one of the underlying causes of the great financial crisis, while at the same time many banks managed to report strong risk-based capital ratios. As a consequence the Basel III framework introduced the leverage ratio (LR) as a simple, non-risk-based "backstop" measure supplementing the risk-based capital measures. Using a unique dataset of wholesale deposit transactions, this paper investigates the effectiveness of LR as backstop measure considering differences of its implementation and calibration across jurisdictions. For identification, I exploit regulatory end of quarter disclosure requirements that penalizes banks' leverage exposure measure with capital surcharges, and differences in implementations of the LR between the United States and the European Union. Based on a conceptual framework of relative constrainedness of LR to risk-weighted capital ratios, I provide evidence that the LR acts as effective backstop measure within the limits of current definition and calibration levels. Moreover, my results advocate the averaging calculation of LR and the introduction of additional LR buffers for systemically important banks in line with risk-based capital buffers in order to strengthen the backstop function and to effectively prevent institutions form taking on excessive and unsustainable leverage risk.