Leverage and Risk-Weighted Capital in Banking Regulation

This paper offers a critical survey of the swings in banking regulation, notably with reference to leverage and risk weighted ratios. At the outset the distinction is made between economic and regulatory capital and between private vs social costs/benefits of equity finance for banking firms. The inherent limitations of the transformation process of assets into a combined size-risk metric, amplified by negative nominal interest rates, are brought to the fore, as well as the relative ease of circumventing the rules. The complexity of regulatory risk weighting creates significant (fixed) compliance costs. Unless appropriate tiering is adopted, a competitive distortion is created in favour of large banking institutions. These shortcomings were especially evident in the Basel II standard. With reference to the Basel III/IV framework it is argued that the two regulatory ratios (leverage and risk weighted capital) can be complementary, but require close and constant supervision, rather than the quest of an optimal (steady state) ex-ante calibration, which may prove time inconsistent. Emphasis should be placed on corporate governance and on the effective interaction between supervisory activity and internal controls. This is usefully complemented by stress-testing techniques which are less model dependent. Potential drawbacks inherent in recent regulatory changes in the U.S. (community banks have now the option of abandoning tiered risk weighted requirements and adopting exclusively a leverage constraint, higher than 9%) are indicated.