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Capital Regulation and Tail Risk

  • Enrico Perotti

    (University of Amsterdam, De Nederlandsche Bank, and Duisenberg School of Finance)

  • Lev Ratnovski

    (International Monetary Fund)

  • Razvan Vlahu

    (De Nederlandsche Bank)

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.

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Article provided by International Journal of Central Banking in its journal International Journal of Central Banking.

Volume (Year): 7 (2011)
Issue (Month): 4 (December)
Pages: 123-163

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Handle: RePEc:ijc:ijcjou:y:2011:q:4:a:5
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