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Risk Shifting with Fuzzy Capital Constraints

Simon Dubecq (), Benoit Mojon () and Xavier Ragot ()

International Journal of Central Banking, 2015, vol. 11, issue 1, 71-101

Abstract: We construct a model where risk shifting can be moderated by capital requirements. Imperfect information about the level of capital per unit of risk, however, introduces uncertainty about the risk exposure of intermediaries. Over-estimation of the capital held by financial intermediaries, or the extent of regulatory arbitrage, may induce households to wrongly infer from higher asset prices that the fundamentals of risky assets have improved. This mechanism can notably explain the low risk premia paid by U.S. financial intermediaries between 2000 and 2007 in spite of their increased exposure to risk through higher leverage. Moreover, the lower the level of the risk-free interest rate, the more risk is under-estimated.

JEL-codes: G14 G21 E52 (search for similar items in EconPapers)
Date: 2015
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Working Paper: Risk Shifting with Fuzzy Capital Constraints (2015)
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