The Disturbing Interaction between Countercyclical Capital Requirements and Systemic Risk

Balint Horvath and Wolf Wagner ()

Review of Finance, 2017, vol. 21, issue 4, 1485-1511

Abstract: We present a model in which flat (state-independent) capital requirements are undesirable because of shocks to bank capital. There is a rationale for countercyclical capital requirements that impose lower capital demands when aggregate bank capital is low. However, such capital requirements also have a cost as they increase systemic risk taking: by insulating banks against aggregate shocks (but not bank-specific ones), they create incentives to invest in correlated activities. As a result, the economy’s sensitivity to shocks increases and systemic crises can become more likely. Capital requirements that directly incentivize banks to become less correlated dominate countercyclical policies as they reduce both systemic risk-taking and cyclicality.

Keywords: Systemic risk; Regulation; Countercylical capital requirements (search for similar items in EconPapers)
JEL-codes: G01 G21 G28 (search for similar items in EconPapers)
Date: 2017
References: View complete reference list from CitEc
Citations: View citations in EconPapers (9)

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