Differential Capital Requirements: Leverage Ratio versus Risk-Based Capital Ratio from a Monitoring Perspective

In this paper, I attempt to amalgamate the study of leverage-ratio performance with the monitoring decisions of a profit-maximizing bank. Applying tools used in studying the industrial organization of banking, my paper serves as a first step to tying the performance differences between the leverage and risk-based constraints to the more fundamental issue of monitoring. Does a bank faced with a leverage based capital constraint monitor its loans better than a bank under a risk-based capital constraint? In a market that is characterized by a dominant bank and fringe banks, I seek to understand if the dominant bank monitors its loan when faced with a Basel III–style leverage ratio. The results show that under certain parameter ranges, the dominant bank will monitor its portfolio when faced with a leverage-based capital constraint. The results also show that the dominant bank will not monitor its portfolio when faced with a risk-based capital constraint.