Regulatory reform in the wake of the recent financial crisis has focused on an increase in capital cushions of financial intermediaries. Basel III rules have doubled the minimal capital ratio, and directed banks to hold excess capital as conservation and counter cyclical buffers above the minimum (BIS, 2010). These arrangements complement traditional moral suasion and individual targets used by regulators to ensure adequate capital cushions.
There are two key arguments in favor of higher capital. The first is an ex post argument: capital can be seen as a buffer that absorbs losses and hence reduces the risk of insolvency. This risk absorption role helps also reduce systemic risk factors, such as collective uncertainty over counterparty risk, which had a devastating propagation effect during the recent crisis. The second considers the ex ante effects of buffers: more capital reduces risk shifting incentives for bank shareholders, by increasing their "skin in the game"(potential loss in case of bank failure), and hence reduces limited liability driven incentives to take excessive risk (Jensen and Meckling 1976, Holmstrom and Tirole 1997).
Yet some recent experience calls for caution. First, banks are increasingly exposed to tail risk, which causes losses only rarely, but when those materialize they often exceed any plausible initial capital. Such risks can result from a number of strategies. A first example are carry trades reliant on short term wholesale funding, which in 2007-2008 produced highly correlated distressed sales (Gorton, 2010). A second example is the reckless underwriting of contingent liabilities on systemic risk, callable at times of collective distress (Acharya and Richardson, 2009). Finally, the combination of higher profits in normal times and massive losses occasionally arises in undiversified industry exposures to inflated housing markets (Shin, 2009). Since under tail risk banks do not internalize losses independently of the level of initial capital, the buffer and incentive effects of capital diminish. Higher capital may become a less effective way of controlling bank risk.
Second, a number of major banks, particularly in the United States, appeared highly capitalized just a couple of years prior to the crisis. Yet these very intermediaries took excessive risks (often tail risk, or highly negatively skewed gambles). In fact, anecdotal evidence suggests that highly capitalized banks were looking for ways to use or put to risk their capital in order to produce returns for shareholders (Berger et al. 2008, Huang and Ratnovski 2009). Therefore higher capital may create incentives for risk taking instead of mitigating them.
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Capital Regulation and Tail Risk
