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Working Paper

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.

Working Papers of the Federal Reserve Bank of Cleveland are preliminary materials circulated to stimulate discussion and critical comment on research in progress. They may not have been subject to the formal editorial review accorded official Federal Reserve Bank of Cleveland publications. The views expressed in this paper are those of the authors and do not represent the views of the Federal Reserve Bank of Cleveland or the Federal Reserve System.


Suggested Citation

Balasubramanyan, Lakshmi. 2014. “Differential Capital Requirements: Leverage Ratio versus Risk-Based Capital Ratio from a Monitoring Perspective.” Federal Reserve Bank of Cleveland, Working Paper No. 14-15. https://doi.org/10.26509/frbc-wp-201415