Regulators will need to be alert for pure regulatory arbitrage – seeking to change the form but not the economic substance of transactions in order to lower regulatory requirements. We have already seen, for example, transactions seeking to take credit risk in the form of derivatives rather than loans in order to lower the leverage exposure measure. More legitimately, banks might switch from activities for which risk weights have increased to activities which carry lower risk weights (Chart 2). The leverage ratio will, however, set an effective floor on the ability of banks to improve their capital position by shifting into low riskweighted assets, providing a safeguard against uncertainties around our estimates of risk. Conversely, banks for which the leverage ratio is a binding requirement may have incentives to move into higher risk-weighted activities (Chart 3) but the risk-weighted ratio should limit the extent of any such risk shifting. In this way, the risk-weighted and leverage ratios should complement one another. It will be interesting to see how banks allocate capital in a world  2  2  http://www.bankofengland.co.uk/publications/Documents/speeches/2014/speech765.pdf. BIS central bankers’ speeches  where they are subject to multiple capital constraints – risk-weighted, leverage and stresstest-based.
1 And third stress testing, to assess capital against the impact of macro-economic scenarios of current concern to policymakers, in the UK modelled partly using firms’ internal models and  1  http://www.bankofengland.co.uk/financialstability/Documents/fpc/fs_lrr.pdf. BIS central bankers’ speeches  1  partly our models. The results of our first concurrent stress tests of major UK banks and building societies will be announced next month. The new bank capital framework will cause banks to hold significantly more capital than the pre-crisis regime. Major UK bank capital requirements and buffers have increased around seven-fold once you take account of tougher definitions of capital, regulatory adjustments to asset valuations and higher risk weights as well as the more obvious increases in headline ratio requirements and buffers. But, to use the language of micro-economics, this significant change in regulatory capital requirements – the “relative prices” of different risks – will lead to substitution as well as income effects. Over time, banks will adjust their portfolios to changed capital requirements. The overall extent to which banks are better capitalised and the financial system is more stable will depend on the scale and nature of these adjustments. Any substitution effects are likely to be stronger if regulation is introduced inconsistently across countries. It is important that we continue to seek consistency in implementing internationally-agreed standards. One adjustment may be a shift in activity from banks to non-banks. That could be beneficial for financial stability: for example, where long-term market-based finance provides an alternative to bank credit.