New kid on the block: leverage ratio and its implications for banking regulation

Abstract

The capital regulation reform package (CRR2) proposed for the EU banking sector introduces a minimum leverage ratio as a (non-risk-weighted) prudential backstop. In this paper, we use Czech bank-level data to explore the implications of introducing a leverage ratio into the capital regulatory framework. Specifically, we create an artificial 'laboratory' environment where we study the relationship between the two regulatory tools and selected bank-specific variables. We identify channels through which the capital and leverage ratios might be affected and test the functionality of those channels. Our results confirm that the capital and leverage ratios complement each other and that the leverage ratio is far less procyclical than the capital ratio. We also demonstrate an over-the-cycle functionality of our proposed channels of interaction between the capital and leverage ratios. We show that the leverage ratio (or similar microprudential backstops, such as an output floor) could be an important tool for maintaining resilience, especially for banking sectors with a high share of banks using the internal rating-based approach to risk weight setting.