Working Paper: CEPR ID: DP8526
Authors: Enrico C. Perotti; Lev Ratnovski; Razvan Vlahu
Abstract: 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 e¤ect of enabling banks to take more tail risk without the fear of breaching the minimal capital ratio in nontail 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.
Keywords: capital regulation; banking risk; risk-taking; systemic risk; tail risk
JEL Codes: G21; G28
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Higher capital (G31) | Lower risk-taking (D81) |
| Tail risk projects (G17) | Increased risk-taking (G41) |
| Higher capital (G31) | Effectiveness of capital as a buffer against losses diminishes under tail risk (G32) |
| Higher capital (G31) | Enables banks to pursue riskier projects (G21) |
| Access to higher tail risk projects (G19) | Negative effect of extra capital on risk-taking becomes more pronounced (G40) |
| Capital regulation must adapt (G28) | Effectively mitigate tail risk (G40) |