In this paper we use a novel approach to address issues of endogeneity in estimating a causal effect of leverage on risk taking by banks. Using data on local bank office deposits and local unemployment we construct an instrument to use in a regression of leverage on a measure of risk taking constructed from new issuance of loans. The results (i.) confirm that due to limited liability banks increase their risk taking after an exogenous increase in leverage, and (ii.) that an increase in deposit supply has a direct positive effect on risk taking by banks.

The ADEMU Working Paper Series is being supported by the European Commission Horizon 2020 European Union funding for Research & Innovation, grant agreement No 649396.