Robust Capital Regulation

Anjan Thakor (), Viral Acharya, Hamid Mehran and Til Schuermann

No 8792, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: We address the following questions concerning bank capital: why are banks so highly levered, what are the consequences of this leverage for the economy as a whole, and how can robust capital regulation be designed to restrict bank leverage to levels that do not generate excessive systemic risk? Bank leverage choices are a delicate balancing act: credit discipline argues for more leverage so that creditors have adequate skin in the game, while balance-sheet opacity and ease of asset substitution by bank managers and shareholders argue for less. Disturbing this balance are regulatory safety nets that promote ex post financial stability but also create perverse incentives for banks to engage in correlated asset choices ex ante and thus hold little equity capital. We discuss how a two-tier capital requirement can cope with these distortions: a core capital requirement like existing capital requirements, and a special capital account that must be invested in Treasuries, accrues to the bank?s shareholders as long as the bank is solvent, and accrues to the regulators (rather than the creditors) if the bank fails. The special capital account requirement ensures creditors have skin in the game and also provides the second margin of safety in the calculation of capital adequacy--a buffer for the regulator?s own "model risk" in calculations of needed capital buffers.

Keywords: Capital requirements; Leverage; Systemic risk; Market discipline; Model risk (search for similar items in EconPapers)
JEL-codes: G12 G21 (search for similar items in EconPapers)
Date: 2012-01
New Economics Papers: this item is included in nep-ban, nep-cba, nep-reg and nep-rmg
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (18)

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Related works:
Journal Article: Robust capital regulation (2012)
Working Paper: Robust capital regulation (2011)
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