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Theoretical considerations and empirical evidence for EU banks provided in this paper suggest that the introduction of an LR requirement into the Basel III regulatory framework should lead to more stable banks.
This paper has shown that although there can indeed exist an increased incentive to take risk once banks become bound by the LR requirement, this increase should be more than outweighed by the synchronous increase in loss-absorbing capacity due to higher capital.
The analysis therefore supports the introduction of an LR alongside the risk-based capital framework. The analysis further suggests that the LR and the risk-based capital framework reinforce each other by covering risks which the other is less able to capture; making sure banks do not operate with excessive leverage and at the same time, have sufficient incentives for keeping risk-taking in check.