Incentives Through the Cycle: Microfounded Macroprudential Regulation

18 Pages Posted: 22 Jan 2011 Last revised: 1 Mar 2013

Date Written: January 20, 2011

Abstract

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

di Iasio, Giovanni and Quagliariello, Mario, Incentives Through the Cycle: Microfounded Macroprudential Regulation (January 20, 2011). Systemic Risk, Basel III, Financial Stability and Regulation 2011. Available at SSRN: https://ssrn.com/abstract=1744325 or http://dx.doi.org/10.2139/ssrn.1744325

Giovanni Di Iasio (Contact Author)

Bank of Italy ( email )

Via Nazionale 91
00184 Roma
Italy

Mario Quagliariello

European Banking Authority ( email )

Floor 46
One Canada Square, Canary Wharf
London, E14 5AA
United Kingdom

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