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Fuzzy Capital Requirements, Risk-Shifting and the Risk Taking Channel of Monetary Policy

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  • Dubecq, S.
  • Mojon, B.
  • Ragot, X.

Abstract

We set up a model where asset price bubbles due to risk shifting can be moderated by capital requirements. However, imperfect information about the ratio of required capital, or, in the context of the sub-prime crisis, the extent of regulatory arbitrage, introduces uncertainty about the risk exposure of intermediaries. Underestimation of regulatory arbitrage may induce households to infer that higher asset prices are due to a decline of risk. First, this mechanism can explain why the risk premia paid by US financial intermediaries did not increase between 2000 and 2007 in spite of its increasing leverage. Second, we provide a theory of the risk taking channel of monetary policy: in the model, the underestimation of risk is larger the lower the level of the risk free interest rate.

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Bibliographic Info

Paper provided by Banque de France in its series Working papers with number 254.

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Length: 35 pages
Date of creation: 2009
Date of revision:
Handle: RePEc:bfr:banfra:254

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Keywords: Capital requirements; Imperfect Information; Risk-taking Channel of monetary policy.;

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  1. Farhi, Emmanuel & Tirole, Jean, 2009. "Collective Moral Hazard, Maturity Mismatch and Systemic Bailouts," IDEI Working Papers 571, Institut d'Économie Industrielle (IDEI), Toulouse, revised Oct 2010.
  2. Gadi Barlevy, 2008. "A leverage-based model of speculative bubbles," Working Paper Series WP-08-01, Federal Reserve Bank of Chicago.
  3. repec:pse:psecon:2005-44 is not listed on IDEAS
  4. Allen, Franklin & Gale, Douglas, 2000. "Bubbles and Crises," Economic Journal, Royal Economic Society, vol. 110(460), pages 236-55, January.
  5. Holmström, Bengt & Tirole, Jean, 1994. "Financial Intermediation, Loanable Funds and the Real Sector," IDEI Working Papers 40, Institut d'Économie Industrielle (IDEI), Toulouse.
  6. John B. Taylor & John C. Williams, 2008. "A black swan in the money market," Working Paper Series 2008-04, Federal Reserve Bank of San Francisco.
  7. Hamerle, Alfred & Liebig, Thilo & Rösch, Daniel, 2003. "Credit Risk Factor Modeling and the Basel II IRB Approach," Discussion Paper Series 2: Banking and Financial Studies 2003,02, Deutsche Bundesbank, Research Centre.
  8. Ciccarelli, Matteo & Peydró, José-Luis & Maddaloni, Angela, 2010. "Trusting the bankers: a new look at the credit channel of monetary policy," Working Paper Series 1228, European Central Bank.
  9. Challe Edouard & Ragot Xavier, 2011. "Bubbles and Self-Fulfilling Crises," The B.E. Journal of Macroeconomics, De Gruyter, vol. 11(1), pages 1-38, May.
  10. Adrian, Tobias & Shin, Hyun Song, 2010. "Liquidity and leverage," Journal of Financial Intermediation, Elsevier, vol. 19(3), pages 418-437, July.
  11. Zhiguo He & Arvind Krishnamurthy, 2008. "A Model of Capital and Crises," NBER Working Papers 14366, National Bureau of Economic Research, Inc.
  12. John Geanakoplos, 2009. "The Leverage Cycle," Cowles Foundation Discussion Papers 1715, Cowles Foundation for Research in Economics, Yale University.
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