Working Paper: CEPR ID: DP8792
Authors: Viral V. Acharya; Hamid Mehran; Til Schuermann; Anjan Thakor
Abstract: We address the following questions concerning bank capital: why are banks so highly levered, what are the consequences of this leverage for the economy as a whole, and how can robust capital regulation be designed to restrict bank leverage to levels that do not generate excessive systemic risk? Bank leverage choices are a delicate balancing act: credit discipline argues for more leverage so that creditors have adequate skin in the game, while balance-sheet opacity and ease of asset substitution by bank managers and shareholders argue for less. Disturbing this balance are regulatory safety nets that promote ex post financial stability but also create perverse incentives for banks to engage in correlated asset choices ex ante and thus hold little equity capital. We discuss how a two-tier capital requirement can cope with these distortions: a core capital requirement like existing capital requirements, and a special capital account that must be invested in Treasuries, accrues to the bank?s shareholders as long as the bank is solvent, and accrues to the regulators (rather than the creditors) if the bank fails. The special capital account requirement ensures creditors have skin in the game and also provides the second margin of safety in the calculation of capital adequacy--a buffer for the regulator?s own "model risk" in calculations of needed capital buffers.
Keywords: capital requirements; leverage; market discipline; model risk; systemic risk
JEL Codes: G12; G21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Higher leverage among banks (G21) | Systemic risk (E44) |
| Regulatory safety nets (G28) | Correlated asset choices (G11) |
| Regulatory safety nets (G28) | Insufficient equity capital (G32) |
| Two-tier capital requirement (G28) | Mitigate risks associated with excessive leverage (G32) |
| Core capital requirement + Special capital account (F32) | Manage distortions (C51) |
| Credit discipline promotes higher leverage (G32) | Ensure creditors have adequate skin in the game (G21) |
| Opacity and ease of asset substitution (E41) | Lower leverage (G19) |
| Special capital account (F32) | Sufficient incentives to monitor bank activities (G28) |