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Capital Regulation and Tail Risk

Author

Listed:
  • Enrico Perotti

    (University of Amsterdam, the Netherlands)

  • Lev Ratnovski

    (International Monetary Fund)

  • Razvan Vlahu

    (Dutch Central Bank DNB, the Netherlands)

Abstract

This discussion paper resulted in a publication in the 'International Journal of Central Banking' , December 2011, 123-163. The paper studies risk mitigation associated with capital regulation, in a context when 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. When capital raising is costly, poorly capitalized banks may limit risk to avoid breaching the minimal capital ratio. A bank with higher capital has lesschance of breaching the ratio, so may actually take more risk. As a result, banks which have access to tail risk projects may take greater risk when highly capitalized.The results are consistent with stylized facts about pre-crisis bank behavior, and suggest implications for the optimal design of capital regulation.

Suggested Citation

  • Enrico Perotti & Lev Ratnovski & Razvan Vlahu, 2011. "Capital Regulation and Tail Risk," Tinbergen Institute Discussion Papers 11-039/2/DSF14, Tinbergen Institute, revised 31 Mar 2011.
  • Handle: RePEc:tin:wpaper:20110039
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    References listed on IDEAS

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    More about this item

    Keywords

    Bank Regulation; Risk Shifting; Capital Requirements; Tail Risk; Systemic Risk;

    JEL classification:

    • E6 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook
    • F3 - International Economics - - International Finance
    • F4 - International Economics - - Macroeconomic Aspects of International Trade and Finance
    • G2 - Financial Economics - - Financial Institutions and Services
    • G3 - Financial Economics - - Corporate Finance and Governance
    • O16 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Financial Markets; Saving and Capital Investment; Corporate Finance and Governance

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