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Capital requirements, risk-taking and welfare in a growing economy

Pierre-Richard Agénor () and Luiz Awazu Pereira da Silva ()

Journal of Regulatory Economics, 2021, vol. 60, issue 2, No 4, 167-192

Abstract: Abstract The effects of capital requirements on risk-taking and welfare are studied in an overlapping generations model of endogenous growth with banking, limited liability, and government guarantees. Capital producers face a choice between a safe technology and a risky, more productive but socially inefficient, technology. Bank risk-taking is endogenous. As a result of a skin in the game effect—motivated either as an aggregate externality, or as the outcome of the optimal choice of monitoring effort by individual banks—default risk is inversely related to the capital adequacy ratio. Numerical simulations show that in an equilibrium where banks extend both safe and risky loans, the skin in the game effect must be sufficiently strong for a welfare-maximizing regulatory policy to exist. These results remain qualitatively similar with endogenous monitoring costs and a strong effect of monitoring on entrepreneurial moral hazard. However, numerical experiments also suggest that the optimal capital adequacy ratio may be too high in practice and may require concomitantly a broadening of the perimeter of regulation and a strengthening of financial supervision to prevent disintermediation and distortions in financial markets.

Keywords: Capital requirements; Bank risk-taking; Bank monitoring; Endogenous growth; Optimal welfare analysis (search for similar items in EconPapers)
JEL-codes: E44 G28 O41 (search for similar items in EconPapers)
Date: 2021
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Related works:
Working Paper: Capital Requirements, Risk-Taking and Welfare in a Growing Economy (2018) Downloads
Working Paper: Capital Requirements, Risk Taking and Welfare in a Growing Economy (2016) Downloads
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DOI: 10.1007/s11149-021-09438-z

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