Capital Regulation and Tail Risk
by Enrico Perottia, Lev Ratnovskib, and Razvan Vlahuc
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.
(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