Regulating bank leverage

Abstract

Purpose This paper aims to study the design of bank capital regulation and points out a conceptual downside of risk-sensitive regulation. The author argues that when a bank is better informed about its risk than the regulator, designing regulation is subject to the Lucas critique. The second-best regulation could be risk-insensitive, which provides an explanation for the leverage ratio as a backstop to risk-based capital requirements. This paper offers empirical predictions and implications for policy. Design/methodology/approach The argument in the paper is based on analytical results from mechanism design. Findings Optimal bank regulation could be risk-insensitive, as is observed in practice in the form of the leverage ratio rule. Originality/value Counter to conventional wisdom, the paper argues and provides a new explanation for why bank regulation should not be sensitive to the risk of the bank. The paper then offers empirical predictions and implications for policy.