The policy discussion about banking regulation during the past two decades has been mainly concerned with capital adequacy. This focus was reinforced by the refinement of existing capital adequacy rules by the Basel Committee which forms the core of the regulatory reform known as “Basel II”. In the debate about how to reform the existing framework questions concerning the general rationale of capital adequacy have been moved to the background. Moreover, whether such regulation can actually serve as a safeguard against financial crises as it is often claimed in policy debates has perhaps received insufficient attention.
In favor of capital adequacy the literature advances two different arguments. On the one hand, capital adequacy is seen as an instrument limiting excessive risk taking of bank owners with limited liability and, thus, promoting optimal risk sharing between bank owners and depositors. On the other hand, capital adequacy regulation is often viewed as a buffer against insolvency crises, limiting the costs of financial distress by reducing the probability of insolvency of banks.
Irrespective of the viewpoint taken, one usually finds a general reference to financial stability, suggesting that capital adequacy regulation provides a safeguard against systemic crises. The mechanism linking capital adequacy and systemic risk remains however usually unexplained. In this paper we provide a new framework in which the dependence between the buffer stock view of bank capital and systemic risk can be discussed more precisely.
Given the extensive literature on capital adequacy regulation (see for instance Freixas and Rochet (1997)), it may appear surprising that the impact of this particular regulatory policy on financial stability has not been analyzed more rigorously. Yet most models in the banking literature deal with a single bank’s decision problem and the incentives of the different claim holders of the bank, in particular of bank owners and managers. With a single bank it is clearly impossible to describe the two major sources of systemic risk: correlated portfolio positions in the banking system and domino-effects in consequence of interbank exposures. Apart from an early paper by Hellwig and Blum (1995) there are few attempts in the literature on capital regulation to move from a single-bank to a system perspective. While financial stability and the macroeconomic consequences of solvency regulation are studied in Gorton and Whinton (1995), Gersbach andWenzelburger (2002), the issue of how financial linkages transmit, and possibly amplify, financial crises has received little attention (see however the papers by Goodhart, Sunidrand, and Tsomocos (2003) and Cifuentes, Ferucci, and Shin (2003)).