Why 'Basel II' May Need a Leverage Ratio Restriction

We analyze regulatory capital requirements where the amount of required capital depends on the level of risk reported by the banks. It is shown that if the supervisors have a limited ability to identify or to sanction dishonest banks, an additional risk-independent leverage ration restriction may be necessary to induce truthful risk reporting. The leverage ration helps to offset the banks' potential capital savings of understating their risks by (i) reducing banks' put option value of limited ex ante, and by (ii) increasing the banks' net worth, which in turn enhances the supervisors' ability to sanction banks ex post.