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 language | English |
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Pages (from-to) | 1485–1511 |
Number of pages | 27 |
Journal | Review of Finance |
Volume | 21 |
Issue number | 4 |
Early online date | 7 Mar 2017 |
DOIs | |
Publication status | Published - Jul 2017 |
Research Groups and Themes
- AF Banking
Keywords
- Systemic risk
- Regulation
- Countercylical capital requirements