The disturbing interaction between countercyclical capital requirements and systemic risk

Balint L Horvath, Wolf Wagner

Research output: Contribution to journalArticle (Academic Journal)peer-review

6 Citations (Scopus)
264 Downloads (Pure)

Abstract

We present a model in which flat (state-independent) capital requirements are undesirable because of shocks to bank capital. There is a rationale for countercyclical capital requirements that impose lower capital demands when aggregate bank capital is low. However, such capital requirements also have a cost as they increase systemic risk-taking: by insulating banks against aggregate shocks (but not bank- specific ones), they create incentives to invest in correlated activities. As a result, the economy's sensitivity to shocks increases and systemic crises can become more likely. Capital requirements that directly incentivize banks to become less correlated dominate countercyclical policies as they reduce both systemic risk-taking and cyclicality.
Original languageEnglish
Pages (from-to)1485–1511
Number of pages27
JournalReview of Finance
Volume21
Issue number4
Early online date7 Mar 2017
DOIs
Publication statusPublished - Jul 2017

Structured keywords

  • AF Banking

Keywords

  • Systemic risk
  • Regulation
  • Countercylical capital requirements

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