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RESEARCH PRODUCT

Capital Regulation with Heterogeneous Banks

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We provide a general 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: Banks are not allowed to absorb the entire supply of debt if they cannot raise new equity, which induces agents with a lower monitoring skill to open a bank. This decreases the average ability of operating banks. We further show that rising heterogeneity in the banking sector increases this negative effect and that additional instruments of the regulator and additional outside options of agents cannot overcome this unintended allocation effect.