Bank Leverage Limits and Regulatory Arbitrage: Old Question‐New Evidence

Abstract

Banks are regulated more than most firms, making them good subjects to study regulatory arbitrage (avoidance). Their latest arbitrage opportunity may be the new leverage rule covering the largest U.S. banks; leverage rules require equal capital against assets with unequal risks, so banks can effectively relax the leverage constraint by increasing asset risk. Consistent with that conjecture, we find that banks covered by the new rule shifted to riskier, higher yielding securities relative to control banks. The shift began almost precisely when the rule was finalized in 2014, well before it took effect in 2018. Security level analysis suggests banks actively added riskier securities, rather than merely shedding safer ones. Despite the risk shifting, overall bank risk did not increase, evidently because the banks most constrained by the new leverage rule significantly increased leverage capital ratios.

Evaluating Regulatory Reform: Banks' Cost of Capital and Lending

“…Leverage requirements may reduce the systematic risk of bank equity by lowering the quantity of bank assets, but may also induce banks to increase asset risk by risk‐shifting (Choi et al. 2019).…”

“…1 However, any rollback in perceived government guarantees may increase the cost of capital. Leverage requirements may reduce the systematic risk of bank equity by lowering the quantity of bank assets, but may also induce banks to increase asset risk by risk-shifting (Choi et al 2019).…”

“…The Federal Reserve mnemonics for the variables used to define the bank characteristics are reported in Appendix TableA.1. The core deposit measure and liquidity coverage measure are fromCalomiris and Nissim (2014) andChoi et al (2019) respectively.…”

“…The core deposit measure includes demand deposits, other noninterest-bearing deposits, and most interest-bearing deposits followingCalomiris and Nissim (2014). The liquidity coverage measure is equal to 100 minus the liquidity stress ratio fromChoi et al (2019). A higher liquidity coverage measure indicates that a bank is more liquid and less exposed to liquidity risk stemming from maturity transformation.…”

The Influence of Liquidity Information on Liquidity Holdings in the Banking System

“…Second, while the capital rule could potentially indirectly affect non-disclosing banks through its impact on disclosing banks, its contribution to the LCR disclosure externality is likely to be small. Risk-insensitive leverage capital requirements (such as the SLR) incentivize banks to increase risky illiquid asset holdings because these assets have the same weight as safe assets in the denominator of the required ratios (Choi, Holcomb, Morgan, et al, 2018), a fact that works against the documented effect of LCR. While risk-based capital requirements discourage illiquid asset holdings, they were primarily implemented in 2014-2015 (followed by phase-in periods until 2018 or 2019).…”