Regulating bank leverage

Abstract

Purpose

This paper aims to study the design of bank capital regulation and points out a conceptual downside of risk-sensitive regulation. The author argues that when a bank is better informed about its risk than the regulator, designing regulation is subject to the Lucas critique. The second-best regulation could be risk-insensitive, which provides an explanation for the leverage ratio as a backstop to risk-based capital requirements. This paper offers empirical predictions and implications for policy.

Design/methodology/approach

The argument in the paper is based on analytical results from mechanism design.

Findings

Optimal bank regulation could be risk-insensitive, as is observed in practice in the form of the leverage ratio rule.

Originality/value

Counter to conventional wisdom, the paper argues and provides a new explanation for why bank regulation should not be sensitive to the risk of the bank. The paper then offers empirical predictions and implications for policy.

Citation

Bleck, A. (2018), "Regulating bank leverage", Journal of Financial Economic Policy, Vol. 10 No. 2, pp. 264-274. https://doi.org/10.1108/JFEP-12-2017-0122