Banks face two sets of capital requirements: (1) risk-based requirements based on the risk of a bank’s assets and (2) leverage requirements based on the size of the bank. Leverage requirements, which are based on size rather than risk, can be thought of as a backstop to ensure that incentives posed by risk-weighted capital ratios do not result in a bank holding insufficient capital. Further, leverage ratios act as a “belt and suspenders” approach to capital regulation that guard against the risk of a particular institution as well as the potential systemic impact a larger asset portfolio may have on the financial system should it succumb. Leverage ratios also proved to be more transparent and therefore instilled more confidence during financial crises.
However, there are policy tradeoffs in using these two types of requirements, particularly for the many banks that face multiple capital requirements. For any particular bank, one of those requirements makes the bank hold the most capital. This is referred to as the binding requirement. If this requirement shifts from a risk-based to a leverage requirement, perverse incentives for banks could arise. For example, a binding leverage requirement creates an incentive to hold riskier assets—as all assets require the same amount of capital — at least up to the point where a bank would hold an equal amount of capital under either risk-based or leverage regimes.
The adequacy of bank capital standards is a perennial debate among policymakers. To study this effect, the US Congressional Research Service (CRS) examined the capital requirements facing the 34 large bank holding companies subject to the Fed’s 2022 stress test. Specifically, CRS examined the largest Tier 1 capital risk-based and leverage requirements to gauge whether binding requirements align with the goals of prudential regulation. Further, given that the largest banks and their holding companies (bank holding companies, or BHCs) face both risk-based and leverage requirements, CRS analyzed the bank subsidiary requirements as well to determine which requirements are driving capital structure and whether policy options for reforming capital regulation could better meet the goals of prudential regulation. (Statute allows qualifying smaller banks to opt out of risk-weighted requirements.)