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January 2015 issue
List of authors
 
in ít Veld, Pagano, Raciborski, Ratto, Roeger
Di Bartolomeo, Tirelli, Acocella
Dubecq, Mojon, Ragot
Damjanovic, Damjanovic, Nolan
Hrung, Seligman
Carlson
Siklos, Neuenkirch
Ennis, Wolman
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Risk Shifting with Fuzzy Capital Constraints

by Simon Dubecqa, Benoit Mojonb and Xavier Ragotc

Abstract

We construct a model where risk shifting can be moderated by capital requirements. Imperfect information about the level of capital per unit of risk, however, introduces uncertainty about the risk exposure of intermediaries. Over-estimation of the capital held by financial intermediaries, or the extent of regulatory arbitrage, may induce households to wrongly infer from higher asset prices that the fundamentals of risky assets have improved. This mechanism can notably explain the low risk premia paid by U.S. financial intermediaries between 2000 and 2007 in spite of their increased exposure to risk through higher leverage. Moreover, the lower the level of the risk-free interest rate, the more risk is under-estimated.

JEL Codes: G14, G21, E52.

 
Full article (PDF, 31 pages, 597 kb)


a European Central Bank
b Banque de France
c CNRS - Paris School of Economics