Working Paper: NBER ID: w11666
Authors: Loriana Pelizzon; Stephen Schaefer
Abstract: Under the New Basel Accord bank capital adequacy rules (Pillar 1) are substantially revised but the introduction of two new "Pillars" is, perhaps, of even greater significance. This paper focuses on Pillar 2 which expands the range of instruments available to the regulator when intervening with banks that are capital inadequate and investigates the complementarity between Pillar 1 (risk-based capital requirements) and Pillar 2. In particular, the paper focuses on the role of closure rules when recapitalization is costly. In the model banks are able to manage their portfolios dynamically and their decisions on recapitalization and capital structure are determined endogenously. A feature of our approach is to consider the costs as well as the benefits of capital regulation and to accommodate the behavioral response of banks in terms of their portfolio strategy and capital structure. The paper argues that problems of capital adequacy are minor unless, in at least some states of the world, banks are able to violate the capital adequacy rules. The paper shows how the role of Pillar 2 depends on the effectiveness of capital regulation, i.e., the extent to which banks can "cheat".
Keywords: No keywords provided
JEL Codes: G21; G28
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Enforcement of pillar 1 rules (G38) | Effectiveness of pillar 2 (I24) |
| Introduction of pillar 2 (Y20) | Bank risk-taking behavior (G21) |
| Pillar 2 acts as a substitute for pillar 1 when capital adequacy rules cannot be enforced (G28) | Necessity and effectiveness of pillar 2 (G28) |
| Level of compliance (L15) | Investment decisions (G11) |
| Extensive cheating (A19) | Probability of bank failure (G21) |
| Pillar 2 PCA (C38) | Present value of deposit insurance liabilities (G28) |
| Limited compliance (K29) | Probability of bank closure (G21) |