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The Disturbing Interaction between Countercyclical Capital Requirements and Systemic Risk

35 Pages Posted: 9 Dec 2012 Last revised: 17 Dec 2013

Bálint L. Horváth

University of Bristol

Wolf Wagner

Erasmus University Rotterdam (EUR) - Rotterdam School of Management (RSM); Centre for Economic Policy Research (CEPR)

Date Written: November 29, 2013

Abstract

We present a model in which flat (cycle-independent) capital requirements are undesirable because of shocks to bank capital. There is a rationale for countercyclical capital requirements that impose lower capital demands when aggregate bank capital is low. However, such capital requirements also have a cost as they increase systemic risk taking: by insulating banks against aggregate shocks (but not bank-specific ones), they create incentives to invest in correlated activities. As a result, the economy's sensitivity to shocks increases and systemic crises can become more likely. Capital requirements that directly incentivize banks to become less correlated dominate countercyclical policies as they reduce both systemic risk-taking and procyclicality.

Keywords: systemic risk, regulation, procyclicality

JEL Classification: G01, G21, G28

Suggested Citation

Horváth, Bálint L. and Wagner, Wolf, The Disturbing Interaction between Countercyclical Capital Requirements and Systemic Risk (November 29, 2013). Available at SSRN: https://ssrn.com/abstract=2187020 or http://dx.doi.org/10.2139/ssrn.2187020

Bálint L. Horváth

University of Bristol ( email )

University of Bristol,
Senate House, Tyndall Avenue
Bristol, BS8 ITH
United Kingdom

Wolf Wagner (Contact Author)

Erasmus University Rotterdam (EUR) - Rotterdam School of Management (RSM) ( email )

P.O. Box 1738
Room T08-21
3000 DR Rotterdam, 3000 DR
Netherlands

Centre for Economic Policy Research (CEPR) ( email )

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

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