Incentives through the cycle: microfounded macroprudential regulation

Giovanni di Iasio () and Mario Quagliariello
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Giovanni di Iasio: Bank of Italy

No 894, Temi di discussione (Economic working papers) from Bank of Italy, Economic Research and International Relations Area

Abstract: We provide a micro-based rationale for macroprudential capital regulation by developing a model in which bankers can privately undertake a costly effort and reduce the probability of adverse shocks to their asset holdings that force liquidation (deterioration risk). Low fundamental risk of assets guarantees benevolent funding conditions and banks are able to expand their balance sheets. The high continuation value would, in principle, improve incentives. However, the rise in asset demand and prices may jeopardize bankers' efforts whenever the liquidation price is high enough. This imposes socially inefficient liquidation which can be corrected with a capital requirement that aligns bankers' incentives. We show that a microprudential regulatory regime that disregards the equilibrium effect of asset prices on incentives performs poorly as low fundamental risk may induce high deterioration risk. Overall, the model suggests a theoretical foundation for the countercyclical capital buffer of Basel III, since it prescribes a macroprudential regulatory regime in which the equilibrium feedback effect is fully taken into account.

Keywords: macroprudential regulation; incentives; financial stability; Basel III; Value-at-Risk; market-based financial intermediaries; financial crises (search for similar items in EconPapers)
JEL-codes: D86 E44 G18 (search for similar items in EconPapers)
Date: 2013-01
New Economics Papers: this item is included in nep-ban, nep-cba, nep-mac and nep-rmg
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Related works:
Working Paper: Incentives through the cycle: microfounded macroprudential regulation (2011)
Working Paper: Incentives through the cycle: microfounded macroprudential regulation (2011)
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Persistent link: https://EconPapers.repec.org/RePEc:bdi:wptemi:td_894_13

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