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A blog on financial markets and their regulation
An IMF working paper by Perotti, Ratnovski and Vlahu (PRV) published earlier this month argues that higher bank capital may not only fail to reduce risk taking, but may have an unintended effect of enabling banks to take more tail risk without the fear of breaching the minimal capital ratio in non-tail risky project realizations. PRV argue that the traditional minimum capital requirement must be supplemented with a maximum capital requirement (realistically, in the form of special attention devoted to banks with particularly high capital) in order to assure that they are not taking tail risk.
The key driver of this result is that, in the PRV model, banks choose between a relatively safe investment and a risky project which has both tail risk and non tail risk. Even though tail risk can be passed on to the government through explicit and implicit bail out, the non tail risk is borne by the bank. Banks facing high levels of non tail risk would rationally hold higher capital to protect themselves from the corrective actions imposed by the regulators when minimum capital levels are breached. In the PRV model, this high level of capital tells the regulator that the bank is bearing a large amount of tail risk as well.
In reality, banks can choose not only between safe assets and risky assets, but also between tail risk and non tail risk. For example, a bank which lends against a residential mortgage bears a significant amount of non tail risk and experiences volatility in earnings requiring capital even in normal situations. As against that, consider a bank that provides liquidity support to a special investment vehicle (SIV) that borrows short term and invests in senior and super senior tranches of a mortgage securitization. In normal times, the SIV earns a nice carry with virtually no risk because the senior tranches are unlikely to default except in systemic crisis events. However, the SIV faces catastrophic tail risk because of the high leverage. The liquidity support provided by the bank to the SIV transfers this tail risk to the bank. In normal times, the SIV produces no losses at all, and the bank produces smooth and predictable earnings with negligible losses. In times of systemic distress, the bank would take large losses, but the bank would rely on a tax payer bail out for coping with this tail risk. A rational bank would therefore set aside negligible capital for its SIV exposure because its non tail risk is low.
By setting up a model in which tail risk and non tail risk are embedded in the same project, the PRV paper does not capture the true risk profile of too big to fail (TBTF) banks that manufacture tail risk to monetize their TBTF status.