Capital regulation with heterogeneous banks – Unintended consequences of a too strict leverage ratio

Abstract

We provide an equilibrium analysis of potential consequences from the introduction of a binding leverage ratio, as proposed in Basel III. If banks differ in their monitoring skills and their ability to successfully complete a risky investment project, a tighter leverage ratio does not only mitigate moral hazard arising from limited liability, but also carries an unintended consequence: high-quality banks are not allowed to absorb the entire supply of debt if it is too costly to issue new equity. This increases the market share of low-skilled bankers and decreases the average ability of operating banks. We further show that rising heterogeneity in the banking sector increases this negative effect.