Bank leverage limits and regulatory arbitrage: new evidence on a recurring question

Dong Beom Choi, Michael R. Holcomb and Donald Morgan

No 856, Staff Reports from Federal Reserve Bank of New York

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.

Keywords: Basel III regulations; bank risk; leverage limits; regulatory arbitrage; reaching for yield (search for similar items in EconPapers)
JEL-codes: G20 G21 G28 (search for similar items in EconPapers)
Date: 2018-06-01
New Economics Papers: this item is included in nep-ban, nep-cfn and nep-rmg
Note: Revised December 2019. Previous title: “Leverage Limits and Bank Risk: New Evidence on an Old Question”
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Citations: View citations in EconPapers (1)

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