DP7819 Banking-on-the-Average Rules

Author(s): Hans Gersbach, Volker Hahn
Publication Date: May 2010
Keyword(s): banking crisis, banking on the average, banking system, equity-capital requirements
JEL(s): G21, G28
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=7819

In this paper, we introduce a new requirement for bank capital: banking-on-the-average rules. Under these rules a bank?s required level of equity capital is monotonically increasing in the realized equity capital of its peers. In a simple model we illustrate the workings of banking-on-the-average rules. We show that in booms these rules can prevent banks from taking excessive risks. Moreover, they alleviate the socially harmful procyclicality of conventional equity-capital rules, which may induce banks to cut back excessively on lending. Finally, we argue that under these rules prudent banks can impose prudency on other banks. In addition, banking-on-the-average rules ensure the build-up of bank equity capital in booms and thus avoid excessive leverage.