A new TCH research note shows that the leverage ratio is a poor measure of bank risk, with many banks that had excellent leverage ratios nevertheless failing during the crisis.  This result may be because, as the note demonstrates, leverage ratio requirements give banks an incentive to increase the riskiness of their portfolios.  The note demonstrates that leverage ratio requirements are influencing bank behavior as predicted, leading banks to pullback from low-risk capital market activities.

Bank capital requirements come in two basic types:  Risk-based capital requirements that require banks to hold more capital for riskier assets and less capital for low risk assets.  And leverage ratio requirements that require banks to hold the same amount of capital for any type of asset, regardless of its risk.

The note explains that leverage ratio requirements have a number of shortcomings because they require banks to hold the same amount of capital against riskless assets as risky assets.  For example, the leverage ratio requirement requires U.S. banks to hold $53 billion in capital against deposits at the Federal Reserve Banks, which are riskless, capital that could be deployed instead toward productive lending to businesses or households.