Liberty Street Economics

« | Main | »

October 12, 2018

Leverage Rule Arbitrage

LSE_Leverage Rule Arbitrage

Classic arbitrage involves the same asset selling at different prices; the leverage rule arbitrage we study here involves assets of different risk levels requiring the same amount of capital. The supplementary leverage ratio (SLR) rule, finalized by U.S. regulators in September 2014, requires a minimum ratio of capital to assets at the largest U.S. banks. The floor is higher for more systemically important banks, but not for banks with riskier assets. That non-risk-based aspect of SLR was intentional, since the leverage limit was meant to backstop (“supplement”) risk-based capital rules in case banks underestimate their asset risk and overstate their capital strength. As policymakers have noted and bankers have warned, if the leverage rule is the binding capital requirement, banks can “arbitrage” the rule by selling safer assets and replacing them with riskier, higher-yielding ones. The findings of our recent staff report are consistent with those concerns.

The Supplementary Leverage Rule

The SLR rule covers only the fifteen largest banks in the United States—those using the “advanced approach” (internal models) for estimating asset risk for setting risk-based capital requirements. When finalized, the rule required a minimum ratio of tier 1 capital to total leverage exposure of 5 percent for globally systemically important banks (G-SIBs, subject to an “enhanced SLR,” or eSLR) and 3 percent for other covered banks.

While U.S. banks already faced a leverage limit, the SLR limit is potentially much more binding than the existing limit because the SLR denominator includes off-balance sheet assets and derivative exposures. For some banks, the SLR limit was also more binding than their risk-based capital requirement; the typical (median) bank in 2013 had less than 1 percentage point of slack relative to the leverage limit, versus 6 percentage points relative to its risk-based capital requirement.

Banks bound by the SLR limit have two options for maintaining compliance: raise capital or shed assets. If a bank chooses to raise capital, it can offset any increase in funding costs by shifting from safer, lower-yielding assets to riskier, higher-yielding ones. If it chooses to reduce assets, the least costly option is to shed low-yielding assets, such as reserves. In either case, that “reach for yield” arbitrage should register as higher security yields or riskier holdings.

Identifying the SLR Effect

We use difference-in-difference (diff-in-diff) analysis to identify potential causal effects of the leverage rule. Essentially, we compare the change in various risk measures at the fifteen banks covered by the rule (SLR banks) before and after September 2014 to the change at the next largest eighteen banks (non-SLR banks), institutions with assets of at least $50 billion. The two sets of banks faced similar (though not identical) post-crisis reforms apart from the SLR rule, so any differential risk change can, given sufficient controls, be attributed to the SLR rule. We studied multiple risk measures, including security yields, riskier (risk-weighted) asset holdings, and overall bank risk measures including leverage.

Reach for Yield?

The chart below suggests a shift toward higher-yielding securities by SLR banks in response to the new leverage rule. Average yields on securities held by SLR and non-SLR banks trended downward roughly in parallel until 2014, with SLR yields being consistently lower. Their paths started to diverge in the third quarter of 2014, with security yields at SLR banks rising, narrowing the gap with those at non-SLR banks.

Leverage Rule Arbitrage

Our formal diff-in-diff estimates confirm that impression. Given bank size, risk-based capital, and other controls, we estimate that mean security yields at SLR banks were 34 basis points (bp) higher relative to those at non-SLR banks after the third quarter of 2014. Reinforcing the causal connection, the effects are larger for SLR banks with less leverage slack (42 bp) than for those with more leverage slack (26 bp).

We find some evidence that this reach reflects active risk-shifting—banks actually adding riskier securities to their portfolio, not merely shedding safer ones. The distinction matters since active risk-shifting, as an act of commission, reveals something about bank behavior or culture and informs the design of incentive-compatible regulation.

Riskier Asset Holdings

Using alternative data, we find consistent evidence that SLR banks increased their holdings of riskier (risk-weighted) security and trading assets relative to non-SLR banks after the leverage rule was finalized. We find some evidence that total assets at SLR banks become riskier, implying that the rule might, perversely, have increased overall bank risk.

Riskier Assets Offset by Deleveraging?

Despite the evident asset shift, we find virtually no change in overall bank risk, not even at the more constrained SLR banks. These overall measures reflect asset risk and leverage, however, and we find that the more constrained SLR banks deleveraged post-SLR (as reflected in the chart below). That reduced leverage may have offset riskier assets, leaving overall risk unchanged.

Leverage Rule Arbitrage

No Arbitrage Opportunities

Our evidence suggests that banks were arbitraging the SLR (and eSLR) rule by shifting from safer assets toward riskier, higher-yielding ones. Evidence from other studies we discuss point to the same behavior by banks or dealers with portfolios heavily weighted toward safe, low-yield assets as part of their business models. Policymakers are aware of this regulatory arbitrage and are addressing it.


The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.

Choi_dongbeomDong Beom Choi is an economist in the Federal Reserve Bank of New York’s Research and Statistics Group.

Michael HolcombMichael R. Holcomb is a senior research analyst in the Bank’s Research and Statistics Group.

Morgan_donaldDonald P. Morgan is an assistant vice president in the Bank’s Research and Statistics Group.

How to cite this blog post:

Dong Beom Choi, Michael R. Holcomb, and Donald P. Morgan, “Leverage Rule Arbitrage,” Federal Reserve Bank of New York Liberty Street Economics (blog), October 12, 2018,

About the Blog

Liberty Street Economics features insight and analysis from New York Fed economists working at the intersection of research and policy. Launched in 2011, the blog takes its name from the Bank’s headquarters at 33 Liberty Street in Manhattan’s Financial District.

The editors are Michael Fleming, Andrew Haughwout, Thomas Klitgaard, and Asani Sarkar, all economists in the Bank’s Research Group.

Liberty Street Economics does not publish new posts during the blackout periods surrounding Federal Open Market Committee meetings.

The views expressed are those of the authors, and do not necessarily reflect the position of the New York Fed or the Federal Reserve System.

Economic Research Tracker

Image of NYFED Economic Research Tracker Icon Liberty Street Economics is available on the iPhone® and iPad® and can be customized by economic research topic or economist.

Economic Inequality

image of inequality icons for the Economic Inequality: A Research Series

This ongoing Liberty Street Economics series analyzes disparities in economic and policy outcomes by race, gender, age, region, income, and other factors.

Most Read this Year

Comment Guidelines


We encourage your comments and queries on our posts and will publish them (below the post) subject to the following guidelines:

Please be brief: Comments are limited to 1,500 characters.

Please be aware: Comments submitted shortly before or during the FOMC blackout may not be published until after the blackout.

Please be relevant: Comments are moderated and will not appear until they have been reviewed to ensure that they are substantive and clearly related to the topic of the post.

Please be respectful: We reserve the right not to post any comment, and will not post comments that are abusive, harassing, obscene, or commercial in nature. No notice will be given regarding whether a submission will or will
not be posted.‎

Comments with links: Please do not include any links in your comment, even if you feel the links will contribute to the discussion. Comments with links will not be posted.

Send Us Feedback

Disclosure Policy

The LSE editors ask authors submitting a post to the blog to confirm that they have no conflicts of interest as defined by the American Economic Association in its Disclosure Policy. If an author has sources of financial support or other interests that could be perceived as influencing the research presented in the post, we disclose that fact in a statement prepared by the author and appended to the author information at the end of the post. If the author has no such interests to disclose, no statement is provided. Note, however, that we do indicate in all cases if a data vendor or other party has a right to review a post.