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|
|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.