Capital Regulation and Tail Risk

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.