Capital Requirements and Bank Risk-Taking under Imperfect Supervision

Abstract

This paper studies the interactions between multiple capital requirements using a novel approach. The approach is based on the classical moral hazard: deposit competition leads to excessive risk-taking by banks. While risk-based capital requirements can reduce this risk-taking incentive, it comes at the cost of banks conducting regulatory capital arbitrage under an internal ratings-based (IRB) approach. This issue is further exacerbated under weak supervisory environment. We study whether adding a non risk-based leverage ratio can reduce arbitrage under imperfect supervision. The model shows that the risk-based capital requirements can reduce bank excessive risk-taking with arbitrage if the regulator imposes enough supervisory power. Once a non risk-based leverage ratio is introduced, arbitrage becomes less likely and the minimum supervisory power to restrict arbitrage also decreases. However, the ratio may induce some prudent banks to invest more aggressively, increasing aggregate risk-taking. Therefore, the banking regulator faces a trade-off between restricting arbitrage and banking stability.