Does Leverage Regulation Effectively Reduce the Systemic Risk of the Banking System? Simulation Analysis Based on the Endogenous Network Model

Lu Lu; Yang Wenhua

doi:doi:10.16538/j.cnki.jfe.2020.02.004

Summary

Deleveraging of the banking system is an important task of financial supply-side structural reform in China, and also a key measure to prevent and resolve financial risks in recent years. With reference to Basel III, China Banking Regulatory Commission formally introduced the leverage regulation indicator in 2011. According to the official data, the leverage ratio of China’s major commercial banks has been higher than the minimum regulatory requirement of 4%, but it is also an indisputable fact that the risk of China’s banking system continues to gather after the financial crisis. So does leverage regulation effectively reduce the systemic risk of the banking system? The answer to this question is related to the effectiveness of the leverage as a macro prudential regulatory tool. However, limited by the lack of empirical data, the complexity of the economic and financial system and other factors, the current literature on the effectiveness of leverage as a macro prudential regulatory tool is rare.　　Therefore, based on the model of Bluhm, et al. (2014), this paper constructs an endogenous network model with leverage constraints, and simulates the risk contagion mechanism and effect under leverage ratio constraints. It is found that in the normal period, leverage regulation will bring the effect of increasing the proportion of risk assets of some banks and decreasing the average degree of network connection between banks. In the crisis period, leverage regulation will increase the number of initial bank failures under exogenous shocks, but will reduce the depth and breadth of risk contagion. On the whole, it is true that the minimum leverage requirement of 4% will lead to a more stable banking system, but the excessive leverage requirement may cause the rise of the systemic risk. In order to maintain the stability of the banking system to the greatest extent, we can implement counter-cyclical and differentiated leverage regulation strategies for banks. At the same time, timely liquidity assistance to the market and improving the loan asset recovery rate of defaulting banks during the crisis will help to enhance the financial stability effect brought by leverage regulation.　　The possible marginal contribution of this paper is as follows: Firstly, compared with the existing litera- ture on the effectiveness evaluation of macro prudential tools, based on the analysis of the endogenous network model, this paper opens the “black box” of leverage regulatory tools affecting the stability of the banking system, and explains the effect and mechanism of leverage regulation. Secondly, the existing endogenous network model usually fails to consider the impact of the introduction of leverage regulation conditions on the stability of the banking system in normal and crisis periods, which is emphasized in this paper. Thirdly, the study of this paper has strong policy significance. The comparative analysis of the regulatory effect of leve- rage under different market parameter combinations provides theoretical support for regulators to formulate more effective leverage regulatory strategies.