Capital Regulation and Tail Risk
IMF Working Papers, August 1, 2011
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Bibliographic details
- Authors: Enrico Camillo Perotti, Lev Ratnovski, Razvan Vlahu
- Published: August 1, 2011
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781462308262.001
Summary
- The paper studies risk mitigation associated with capital regulation in a context where banks may choose tail risk assets.
- Key finding: higher capital does not necessarily reduce excess risk-taking driven by limited liability; instead, it can undermine the traditional result that high capital reduces such risk-taking.
- Additional finding: higher capital may enable banks to take more tail risk without fearing breach of 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.
Main findings and analysis
- Higher capital can have the unintended effect of enabling banks to increase tail risk exposure.
- The traditional view—that higher capital reduces excess risk-taking due to limited liability—is undermined when banks can choose tail risk assets.
- The model results align with stylized facts observed in pre-crisis bank behavior.
Policy implications and recommendations
- Capital regulation design should account for the possibility that increasing capital requirements could encourage selection of tail-risk projects.
- Optimal capital regulation requires attention to banks' portfolio choices, including incentives to shift into tail risk assets when capital is higher.
- Consideration of recapitalization costs and project-choice incentives is important for calibrating capital adequacy requirements and countercyclical capital buffers.
Research context and scope
- Subject areas: Bank regulation; Banking; Capital adequacy requirements; Countercyclical capital buffers; Financial crises; Financial regulation and supervision; Tax incentives.
- Keywords: adjustment cost; adjustment effect; bank capital; Bank regulation; Capital adequacy requirements; capital ratio; Capital Regulation; capital requirement; Countercyclical capital buffers; Financial Innovation; project choice; recapitalization cost; recapitalization decision; Risk Management; risk profile; Tail Risk; WP.