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Should Bank Capital Regulation Be Risk Sensitive?

Toni Ahnert (), James Chapman () and Carolyn Wilkins

Staff Working Papers from Bank of Canada

Abstract: We present a simple model to study the risk sensitivity of capital regulation. A banker funds investment with uninsured deposits and costly capital, where capital resolves a moral hazard problem in the banker’s choice of risk. Investors are uninformed about investment quality, but a regulator receives a signal about it and imposes minimum capital requirements. With a perfect signal, capital requirements are risk sensitive and achieve the first-best levels of risk and intermediation: safer banks attract cheaper deposit funding and require less capital. With a noisy signal, risk-sensitive capital regulation can implement a separating equilibrium in which low-quality banks do not participate. We show that the degree of risk sensitivity is non-monotone in the precision of the signal and in investment characteristics. Without a signal, a leverage ratio still induces the efficient risk choice but leads to excessive or insufficient intermediation.

Keywords: Financial institutions; Financial system regulation and policies (search for similar items in EconPapers)
JEL-codes: G21 G28 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-ban, nep-cba and nep-rmg
Date: 2018
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Persistent link: https://EconPapers.repec.org/RePEc:bca:bocawp:18-48

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