In Europe, without a leverage ratio but with risk-based capital standards, there were incentives for banks to expand balance sheets and shade downwards risk weights. Canadian banks’ incentives sat somewhere in between. Some recent studies have looked at these behavioural shifts in greater detail. During the euro-area crisis, banks increased their exposure toward higher risk government bonds, which carried no capital requirement (Acharya and Steffen (2015)). And following the Lehman crisis, German banks reduced their corporate lending less when the capital requirement was set under the standardised approach (Behn, Haselmann, Wachtel (2016)). In the UK, higher risk mortgages shifted towards lenders whose capital requirements were less risk-sensitive after the introduction of Basel II (Benetton et al (2017)). Recent research has considered how the leverage ratio announcement affected behaviour among a panel of over 650 European banks (Acosta-Smith et al (2017)). It finds a significant increase in risk-taking among those banks for whom the new regime was a binding constraint. This risk-taking was greater, the further these banks were from meeting the new 3% threshold: banks with leverage ratios of 1.5%, 2% and 2.5% were found to increase their risk-taking by 3.4, 2.3 and 1.1 percentage points of risk-weighted assets respectively. This is clear empirical evidence of the risk-shifting channel at work. This is only, however, one side of the risk equation. There were two mitigating factors on the other side. First, a rise in the leverage ratio also boosts these banks’ capital.

Moreover, it was plausibly the case that pre-crisis liquidity may have been too plentiful and too cheap in some financial markets, so some correction in the quantity and pricing of liquidity was to be expected, and indeed was potentially desirable, from a welfare perspective. Research at the Bank of England has sought to identify the impact of leverage ratio requirements on the functioning of UK government bond (‘gilt’) and gilt repo markets, using transaction-level data (Bicu et al (forthcoming)).18 It does find some causal impact of the leverage requirement on various metrics of liquidity, a worsening that is particularly acute at quarter-ends. Significantly, the banks most constrained by the leverage ratio reduced their activity in financial markets most. At the same time, however, dealers unaffected by the leverage ratio requirement also reduced their liquidity provision and, if anything, by more. This suggests factors other than the leverage ratio may have been at work in curtailing liquidity in these markets. It also leaves open the question of whether the correction in liquidity, even if privately costly, came at any social cost. Baranova, Liu and Shakir (2017) assess the costs that could arise from regulation which affects market liquidity at different levels of stress. They find higher costs in benign conditions, but substantial benefits in situations of stress as dealers make markets for longer. Overall Implications for Optimal Capital  How do these research findings tilt the optimal bank capital calculus relative to the LEI study? Table 1 summarises the evidence. They are a mixed bag.