Template-Type: ReDIF-Paper 1.0 Series: Tinbergen Institute Discussion Papers Creation-Date: 2011-02-17 Revision-Date: 2011-03-31 Number: 11-039/2/DSF14 Author-Name: Enrico Perotti Author-Workplace-Name: University of Amsterdam, the Netherlands Author-Name: Lev Ratnovski Author-Workplace-Name: International Monetary Fund Author-Name: Razvan Vlahu Author-Workplace-Name: Dutch Central Bank DNB, the Netherlands Title: Capital Regulation and Tail Risk Abstract: This discussion paper resulted in a publication in the 'International Journal of Central Banking', December 2011, 123-163.
The paper studies risk mitigation associated with capital regulation, in a context when banks may choose tail risk assets. We show that this undermines the traditional result that higher capital reduces excess risk-taking driven by limited liability. When capital raising is costly, poorly capitalized banks may limit risk to avoid breaching the minimal capital ratio. A bank with higher capital has lesschance of breaching the ratio, so may actually take more risk. As a result, banks which have access to tail risk projects may take greater risk when highly capitalized.The results are consistent with stylized facts about pre-crisis bank behavior, and suggest implications for the optimal design of capital regulation. Classification-JEL: E6, F3, F4, G2, G3, O16 Keywords: Bank Regulation, Risk Shifting, Capital Requirements, Tail Risk, Systemic Risk File-Url: http://papers.tinbergen.nl/11039.pdf File-Format: application/pdf File-Size: 388435 bytes Handle: RePEc:tin:wpaper:20110039