The impact of higher leverage ratios on the South African economy

Abstract We employ a micro-founded, stock-flow consistent computable general equilibrium model to study the impact of increases of the leverage ratio on the South African economy. The model provides for a richer representation of institutional balance sheets than existing models and captures the important relationship identified in the literature between bank capital, lending spreads and economic activity. The financial accelerator mechanism operates through the balance sheets of all institutions in the economy. The move to a higher leverage ratio for banks is likely in the short-run to generate negative economic impacts that depend on the banks’ choice of adjustment strategy. The negative GDP effect is greatest if the financial sector reduces leverage by reducing the value of its assets rather than raising its liabilities. The shock also leads to the financial sector changing its perceptions of risk, which reduces the size of the money multiplier and increases lending spreads. The transition to a higher leverage ratio also affect the transmission of monetary policy. Executing monetary policy effectively thus requires understanding how the financial sector is likely to meet the new requirements and how its perceptions of risk are affected.