Cyclical adjustment of capital requirements: A simple framework |
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Institution: | 1. Departamento de Economía, Universidad Diego Portales, Chile;2. Centro de Economía Aplicada, Departamento de Ingeniería Industrial, Universidad de Chile, Chile;3. University of Pennsylvania, United States;1. Department of Economics, Carleton University, Canada;2. School of Accounting and Finance, University of Waterloo, Canada |
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Abstract: | We present a model of an economy with heterogeneous banks that may be funded with uninsured deposits and equity capital. Capital serves to ameliorate a moral hazard problem in the choice of risk. There is a fixed aggregate supply of bank capital, so the cost of capital is endogenous. A regulator sets risk-sensitive capital requirements in order to maximize a social welfare function that incorporates a social cost of bank failure. We consider the effect of a negative shock to the supply of bank capital and show that optimal capital requirements should be lowered. Failure to do so would keep banks safer but produce a large reduction in aggregate investment. The result provides a rationale for the cyclical adjustment of risk-sensitive capital requirements. |
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Keywords: | Banking regulation Basel II Capital requirements Procyclicality |
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