Incentives Through the Cycle: Microfounded Macroprudential Regulation
18 Pages Posted: 22 Jan 2011 Last revised: 1 Mar 2013
Date Written: January 20, 2011
We provide a new rationale for macroprudential capital regulation by developing a model where banks can privately undertake a costly effort and reduce the probability of adverse shocks to their asset holdings and liquidation (deterioration risk). Low fundamental risk guarantees benevolent funding conditions and banks are able to expand their balance sheet. The associated boost in asset demand and prices may jeopardize banks’ incentives whenever the liquidation price raises. We show that a microprudential regulatory regime that disregards the equilibrium effect of asset prices on banks’ effort performs poorly as low fundamental risk may induce high deterioration risk. Overall, the model suggests a theoretical foundation for the countercyclical buffer of Basel III, since it prescribes a macroprudential regulatory regime in which the equilibrium feedback effect is fully taken into account by the authority.
Keywords: Macroprudential regulation, incentives, financial stability, Basel III, Value-at-Risk
JEL Classification: E44, D86, G18
Suggested Citation: Suggested Citation