Should bank capital regulation be risk sensitive?

Toni Ahnert, James Chapman and Carolyn Wilkins

Journal of Financial Intermediation, 2021, vol. 46, issue C

Abstract: We present a screening model of the risk sensitivity of bank capital regulation. A banker funds a project with uninsured deposits and costly capital. Capital resolves a moral hazard problem in the choice of the probability of default (PD). The project’s loss given default (LGD) is the banker’s private information. The regulator receives a noisy signal about the LGD and imposes a minimum capital requirement. We show that the optimal sensitivity of capital regulation is non-monotonic in the accuracy of risk assessment. If the signal is inaccurate, the regulator should use risk-insensitive capital requirements. Given sufficient accuracy, the regulator should separate types via risk-sensitive capital requirements, reducing the risk-sensitivity of bank capital as accuracy improves.

Keywords: Bank capital; Regulation; Risk sensitivity; Moral hazard; Adverse selection (search for similar items in EconPapers)
Date: 2021
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Citations: View citations in EconPapers (3)

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Working Paper: Should Bank Capital Regulation Be Risk Sensitive? (2018)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:jfinin:v:46:y:2021:i:c:s1042957320300243

DOI: 10.1016/j.jfi.2020.100870

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