The Puzzle of Bank Leverage: Between Theory and Reality

The financial accelerator model, introduced by Bernanke, Gertler, and Gilchrist (1994, 1999), revolutionized macroeconomics by showing how credit market frictions amplify economic shocks. Their core insight was that banks, constrained by capital requirements, magnify both positive and negative shocks due to high leverage, sometimes exceeding a 10:1 debt-to-equity ratio. This mechanism became the foundation of financial friction literature, with later work by Gertler, Kiyotaki, and Karadi (2010-2016) incorporating banks’ moral hazard problems and their role in crises. Yet, a critical assumption underlies these models: banks always maximize leverage within regulatory limits because doing so is optimal. But does real-world banking behavior align with this assumption?

A dominant strand of research argues that high bank leverage is economically justified. DeAngelo and Stulz (2015), Hanson et al. (2015), and Hart and Zingales (2015) contend that banks, by diversifying their loan portfolios, can minimize risk while offering low-cost, safe deposits essential for households that rely on banks for intertemporal savings. In this view, leverage is not reckless but efficient, allowing banks to intermediate funds at scale while maintaining stability. Regulatory capital requirements, then, act as a necessary backstop rather than a binding constraint.

However, critics like Admati and Hellwig (2014) warn that high leverage makes banks vulnerable to financial distress, increasing systemic risk. Their argument is bolstered by empirical evidence as Gambacorta and Shin (2018) found that even a modest increase in bank equity reduces funding costs and boosts lending, suggesting that higher capital buffers could enhance stability without sacrificing growth. If higher capital is so beneficial, why do banks still operate with such thin equity cushions? The traditional answer is profit maximization, yet recent data challenges this assumption.

Contrary to theoretical predictions, Gropp and Heider (2010) found that banks often maintain capital ratios well above regulatory minimums. This "discretionary capital" suggests that banks do not always lever up to the maximum allowed, possibly due to market discipline, risk management, or signaling strength to investors. If banks voluntarily hold extra capital, the foundational assumption of the financial accelerator that banks are tightly constrained need revisiting. This raises deeper questions. Are leverage decisions driven more by market forces than regulation? Do banks prioritize stability over short-term profits in ways models ignore?

The gap between theory and reality calls for a reassessment of financial friction models. If banks do not maximize leverage, the amplification effects of shocks may be weaker than predicted. Policymakers must consider whether capital requirements are as binding as assumed, or if market incentives already push banks toward safer buffers. Future research should explore why banks hold excess capital and how this behavior alters crisis dynamics.