XXV Edition

1-2 December 2016"

Bank Regulation in a Complex Environment

Nielsen Carsten, Catholic University of the Sacred Heart, Milan
Weinrich Gerd, Catholic University of the Sacred Heart, Milan

We study risk based capital requirements in a monopolistic competition, general equilibrium model. Banks may invest in suboptimal gambling assets rather than risky assets (which we interpret as lending to firms). Capital requirements are used to address this moral hazard problem but may (inadvertently) induce banks to switch into a class of safe assets which are not subject to capital requirements but not optimal either. Our model may contribute to the understanding of the recent contraction in bank funds to European firms despite the quantitative easing by the European Central Bank. Our model suggests as explanation the very design of the Basel accords rather than procyclicality in the traditional sense. Furthermore, since optimizing banks may choose to voluntarily hold capital buffers in response to increased capital requirements, our model also provides a perspective on the new mandatory capital buffers under Basel III.

Area: Financial Regulation and Supervision

Keywords: Bank regulation, moral hazard, procyclicality, capital requirements, endogenous capital buffers

Paper file

University Network