DP8526 Capital Regulation and Tail Risk

Author(s): Enrico C Perotti, Lev Ratnovski, Razvan Vlahu
Publication Date: August 2011
Keyword(s): Capital regulation, Keywords: Banking, Risk, Risk-taking, Systemic risk, Tail risk
JEL(s): G21, G28
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=8526

The paper studies risk mitigation associated with capital regulation, in a context where 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. Moreover, higher capital may have an unintended e¤ect of enabling banks to take more tail risk without the fear of breaching the minimal capital ratio in nontail risky project realizations. The results are consistent with stylized facts about pre-crisis bank behavior, and suggest implications for the optimal design of capital regulation.