Study makes the case for flexible limits on bank leverage

Keeping banks strong and solvent during both prosperous and difficult economic periods requires flexibility, not a set of uniformly strict regulations.

That’s the conclusion of WashU Olin Professor Brittany Lewis, who says her research shows that the best approach to bank regulation may be tightening the rules when times are good and loosening them to give a struggling economy a boost.  

Lewis, an assistant professor of finance, developed a methodology to assess the optimal amount of leverage, or money that banks are allowed to borrow for investment.  

Her methodology would allow regulators to run simulations of how the economy would react to changes in bank leverage restrictions. “In a time of crisis, we could see which leverage restrictions would give us the optimal outcome,” Lewis said. 

Her goal is to prevent bank runs, a situation in which banks suddenly find themselves unable to borrow money, causing more serious contractions across the greater economy. 

 

When you’re in a poor state of the world, you want banks to be able to take on leverage because they can get money where it needs to be so we can make investments and build the economy back up. 

Brittany Lewis

Lewis’ paper, “Bank Leverage Restrictions in General Equilibrium: Solving for Sectoral Value Functions,” was published in the Journal of Risk Financial Management in fall 2025. 

Leverage: balancing stability and growth 

Ever since the Great Global Financial Crisis of 2007–2009, regulators have debated how to regulate banks to prevent a repeat. Reforms included creating a fixed leverage requirement for banks to prevent them from becoming overloaded with risky debt. 

But Lewis says regulating bank leverage is tricky, particularly after a financial crisis. While tighter leverage restrictions can improve economic stability, they can stymie growth just when a recovering economy needs it most. She argues that flexible requirements are a better solution when economic conditions are changing. 

“When you’re in a poor state of the world, you want banks to be able to take on leverage because they can get money where it needs to be so we can make investments and build the economy back up,” Lewis said. 

As an example, she points to the COVID-19 pandemic, when the U.S. government tried to jump-start the economy with emergency credit programs that helped carry out the Coronavirus Aid, Relief, and Economic Security (CARES) Act. This required banks to take on additional safe assets — U.S. Treasuries and bank reserves. But because of leverage restrictions, banks couldn’t do that, so the federal government temporarily relaxed the bank requirements to allow it. 

Lewis called leverage “a double-edged sword,” noting that if a bank becomes over-leveraged with high-risk debt, it’s vulnerable to having depositors or lenders run on the bank. 

While a bank run may conjure up grainy Depression-era pictures of depositors lined up outside a bank building waiting to withdraw their money, a modern bank run looks different, she said. 

The main actors are likely to be large cash lenders like money-market mutual funds, who ordinarily lend money to banks on a daily basis through what’s called the repo market. If they become concerned about a bank’s solidity, they may stop this lending abruptly. 

“You won’t see people lining up at the bank waiting to withdraw their money,” Lewis said. “It will happen via computers, and it’ll happen overnight. And then the public would feel it — it would be really hard for you to get a credit card, or to get forbearance on your mortgage if you lose your job. The bank says, ‘I can’t do it, because I don’t have any money.’”  

This, in effect, is what happened during the Global Financial Crisis, she said. 

A methodology to guide decisions  

Lewis has been working in this area for about a decade, exploring the causes of the Global Financial Crisis and the levers that could be used to prevent another one.   

The methodology she has developed would vary bank leveraging restrictions based on the health of the economy, as shown by indicators such as unemployment rates, credit spreads, or consumption rates.   

In difficult economic times, bank leverage restrictions would be looser, allowing for banks to make investments that could help recharge the economy. When the indicators show that times are easier, these leverage requirements would be tighter, to ensure banks’ debt doesn’t become too risky.  

Using simulations, Lewis showed that this flexible approach enhances the economy’s overall welfare.  

Decisions about when and how much to change leverage requirements would likely be in the hands of the Federal Reserve, the central banking system of the United States. Lewis said it could be accomplished through an algorithm based on the economic indicators, but the Federal Reserve could also choose to intervene as needed on its own.  

She believes Congress also has a significant role to play. Lewis noted that a Congressional Act passed in 2005 changed how mortgage-backed securities (used as collateral in repo loans to banks) were treated in bankruptcy. That helped set the gears in motion that caused the financial crisis a few years later.  

“One use of this (methodology) could be for Congress to use it when they consider changing the bankruptcy code,” Lewis said.  

Photo caption: While modern bank runs don’t look like those experienced during the Great Depression, they still pose a threat to the economy.