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

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;

JEL Classification: G20; G21; G28;

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Bibliographic Information

Provider: Federal Reserve Bank of New York

Part of Series: Staff Reports

Publication Date: 2018-06-01

Number: 856

Note: Revised December 2019. Previous title: “Leverage Limits and Bank Risk: New Evidence on an Old Question”