Please use this identifier to cite or link to this item: http://hdl.handle.net/10419/197901
Authors: 
Ahnert, Toni
Chapman, James
Wilkins, Carolyn
Year of Publication: 
2018
Series/Report no.: 
Bank of Canada Staff Working Paper No. 2018-48
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.
Subjects: 
Financial institutions
Financial system regulation and policies
JEL: 
G21
G28
Document Type: 
Working Paper

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