The leverage ratio: a balance between risk and safety
What was the root cause of the financial crisis? Ask any economist or banker and undoubtedly they will at some point mention leverage (see e.g. here, here and here). Yet when a capital requirement based on leverage — the leverage ratio requirement — was introduced, fierce criticism followed (see e.g. here and here). Drawing on the insights from a working paper, and thinking about the main criticism — that a leverage ratio requirement could cause excessive risk-taking — this seems not to have been the case.
It has been said that a leverage ratio requirement is akin to setting the same speed limit on every single road. This, however, is incorrect. It’s actually more like imposing a national maximum speed limit, and there’s a lot of evidence this increases road safety. The authorities can always impose different speed limits on other roads depending on risk, and the same is true through the combination of the leverage ratio and the risk-based requirement.
While there may be some increased risk-taking at the margin, this needs to be put into perspective: the evidence would suggest it’s outweighed by the benefit of higher loss-absorbing capacity.
The full article and working paper are available at https://bankunderground.co.uk/2020/10/06/the-leverage-ratio-a-balance-between-risk-and-safety/