Working Paper: CEPR ID: DP9008
Authors: Rafael Repullo
Abstract: We present a simple model of an economy with heterogeneous banks that may be funded with uninsured deposits and equity capital. Capital serves to ameliorate a moral hazard problem in the choice of risk. There is a fixed aggregate supply of bank capital, so the cost of capital is endogenous. A regulator sets risk-sensitive capital requirements in order to maximize a social welfare function that incorporates a social cost of bank failure. We consider the effect of a negative shock to the supply of bank capital and show that optimal capital requirements should be lowered. Failure to do so would keep banks safer but produce a large reduction in aggregate investment. The result provides a rationale for the cyclical adjustment of risk-sensitive capital requirements.
Keywords: banking regulation; Basel II; capital requirements; procyclicality
JEL Codes: E44; G21; G28
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Negative shock to bank capital supply (F65) | Reduction in optimal capital requirements (G32) |
| Reduction in optimal capital requirements (G32) | Increase in bank risk-taking behavior (G21) |
| Reduction in optimal capital requirements (G32) | Significant reduction in aggregate investment (E22) |
| Optimal regulation involves trade-off between bank safety and investment levels (G28) | Reduction in capital requirements in response to capital scarcity (O16) |
| Failure to lower capital requirements after a capital shock (G28) | Reduction in economic activity (F69) |