Benefits and costs of a higher bank “leverage ratio”

Banking legislation and regulation in the U.S. has historically been driven more by the politics of banking than sound economic analysis. Following the most recent and severe banking crisis since the Great Depression, legislation has been enacted that instructs banking authorities to impose stricter and higher capital requirements on banks, among other more stringent regulations. In this study, we generate estimates of the marginal benefits and costs arising from increasing the equity-to-asset "leverage ratio" for banks from 4 percent to 15 percent. We use limited dependent variable methods to estimate the relationship between the changes in the probability of a banking crisis and increases in the leverage ratio from 1892-2014, which we multiply by the estimated loss per crisis that varies depending on the assumed temporary nature of shocks to generate the marginal benefits. We weigh these marginal benefits against the marginal costs in terms of reduced lending, arising from banks passing off the higher equity costs resulting from a higher leverage ratio onto borrowers. Unlike many recent studies, we assume no "Modigliani-Miller offset" exists, in the sense that banks with greater equity funding are not safer in the sense of offering a lower expected return. In our baseline case, we find that the optimal leverage ratio equals 19 percent. Furthermore, the marginal benefits equal or exceed marginal costs under a wide variety of assumptions. A tax advantage of debt, or a larger fraction of corporate funding coming from debt tends to drive up marginal costs relative to marginal benefits. Assuming that shocks have only temporary effects, that the temporary effects have a shorter duration, or that there is a smaller cost of a crisis tends to decrease the marginal benefits relative to the costs.