# 11-039/2/DSF14 (2011-02-17; 2011-03-31)

Enrico Perotti, University of Amsterdam, the Netherlands; Lev Ratnovski, International Monetary Fund; Razvan Vlahu, Dutch Central Bank DNB, the Netherlands
Bank Regulation, Risk Shifting, Capital Requirements, Tail Risk, Systemic Risk
JEL codes:
E6, F3, F4, G2, G3, O16

This discussion paper resulted in a publication in the 'International Journal of Central Banking', December 2011, 123-163.

The paper studies risk mitigation associated with capital regulation, in a context when banks may choose tail risk assets. We show that this undermines the traditional result that higher capital reduces excess risk-taking driven by limited liability. When capital raising is costly, poorly capitalized banks may limit risk to avoid breaching the minimal capital ratio. A bank with higher capital has lesschance of breaching the ratio, so may actually take more risk. As a result, banks which have access to tail risk projects may take greater risk when highly capitalized.The results are consistent with stylized facts about pre-crisis bank behavior, and suggest implications for the optimal design of capital regulation.