This paper addresses the trade-off between additional loss-absorbing ca- pacity and potentially higher bank risk-taking associated with the introduc- tion of the Basel III Leverage Ratio. This is addressed in both a theoretical and empirical setting. Using a theoretical micro model, we show that a leverage ratio requirement can incentivise banks that are bound by it to increase their risk-taking. This increase in risk-taking however, should be more than outweighed by the benefits of higher capital and therefore increased loss-absorbing capacity, thereby leading to more stable banks. These theoretical predictions are tested and confirmed in an empirical analysis on a large sample of EU banks. Our baseline empirical model suggests that a leverage ratio requirement would lead to a significant decline in the distress probability of highly leveraged banks.
The full white paper is available at https://www.ecb.europa.eu/pub/pdf/scpwps/ecb.wp2079.en.pdf