On the Effectiveness of Capital Requirements

This article demonstrates that the effectiveness of capital requirements in reducing default risk depends on the risk-taking behaviour of financial intermediaries. Capital requirements with risk weights that are not proportional to expected excess returns create adverse incentives that may lead to an increase in default risk through short-sales. We establish the coefficient of variation of future net worth as a measure of default risk and show that non-proportional risk weights can never be calibrated such that all intermediaries reduce default risk. Since default risk depends non-linearly on equity, it will increase with higher equity and thus with inappropriately chosen capital coefficients whenever the willingness to assume risk is sufficiently elastic.