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Capital Regulation and Tail Risk

  • Enrico Perotti
  • Lev Ratnovski
  • Razvan Vlahu

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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File URL: http://www.dnb.nl/en/binaries/working%20paper%20307_tcm47-256588.pdf
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Paper provided by Netherlands Central Bank, Research Department in its series DNB Working Papers with number 307.

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Date of creation: Aug 2011
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Handle: RePEc:dnb:dnbwpp:307
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Web page: http://www.dnb.nl/en/

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