The procyclicality of Basel III leverage: Elasticity-based indicators and the Kalman filter

Traditional leverage ratios assume that bank equity captures all changes in asset values. However, in the context of market-oriented banking, capital can be funded by additional debt or asset sales without directly influencing equity. Given the new sources of liquidity generated by off-balance-sheet (OBS), time-varying indicators of leverage are better suited to capture the dynamics of aggregate leverage. In this paper, we introduce a Kalman filter procedure to study such elasticity-based measures of broad leverage. This approach enables the detection of the build-up in bank risk years before what the traditional assets to equity ratio predicts. Most elasticity measures appear in line with the historical episodes, well tracking the cyclical pattern of leverage. Importantly, the degree of total leverage suggests that OBS banking exerts a stronger influence on leverage during expansion periods.