- Capital regulation and tail risk
- Amsterdam: Tinbergen Institute
- Tinbergen Institute Discussion Paper
- Volume | Edition (Serie)
- Document type
- Working paper
- Faculty of Economics and Business (FEB)
- Amsterdam Business School Research Institute (ABS-RI)
The paper studies risk mitigation associated with capital regulation, in a context when banks may choose tail risk assets. We show that this undermines the traditional result that higher capital reduces excess risk-taking driven by limited liability. When capital raising is costly, poorly capitalized banks may limit risk to avoid breaching the minimal capital ratio. A bank with higher capital has less chance of breaching the ratio, so may actually take more risk. As a result, banks which have access to tail risk projects may take greater risk when highly capitalized. The results are consistent with stylized facts about pre-crisis bank behavior, and suggest implications for the optimal design of capital regulation.
- Duisenberg School of Finance: DSF 11. - March 2011
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