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December 2011 issue
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Gale, Repullo, Smets
Perotti, Suarez
Pariès, Sørensen, Rodriguez-Palenzuela
Perotti, Ratnovski, Vlahu
Herring
Drehmann, Borio, Tsatsaronis
Edge, Meisenzahl
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Capital Regulation and Tail Risk

by Enrico Perottia, Lev Ratnovskib, and Razvan Vlahuc

Abstract

The paper studies risk mitigation associated with capital regulation, in a context where 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. Moreover, higher capital may have an unintended effect of enabling banks to take more tail risk without the fear of breaching the minimal capital ratio in non-tail risky project realizations. The results are consistent with stylized facts about pre-crisis bank behavior, and suggest implications for the optimal design of capital regulation.

JEL Codes: G21, G28.

 
Full article (PDF, 41 pages 478 kb)

Discussion by Andrew Winton


a University of Amsterdam, De Nederlandsche Bank, and Duisenberg School of Finance
b International Monetary Fund
c De Nederlandsche Bank