BIS research tests leverage ratio with adjusted DSGE model

An updated general equilibrium model implies the Basel III leverage ratio can deliver significant benefits, a working paper published by the Bank for International Settlements finds.

Published today (September 30), the work by Leonardo Gambacorta and Sudipto Karmakar focuses on designing a dynamic stochastic general equilibrium model that reflects both leverage and risk-weighted capital constraints. They allow risk weights to vary on lending to households and non-financial firms to better reflect reality.

The model implies the leverage ratio is more counter-cyclical than risk-weighted requirements, the benefits are "substantially higher" than the costs, and the steady state values of each ratio "depend strongly" on the riskiness and composition of lending portfolios.

They note their model does not allow for bank defaults in equilibrium, for which reason they restrict themselves to "strictly" positive analysis – rather than normative questions such as the optimal level of the leverage ratio.