Incentives Through the Cycle: Microfounded Macroprudential Regulation

30 Pages Posted: 21 Feb 2013

Date Written: January 30, 2013

Abstract

We provide a micro-based rationale for macroprudential capital regulation by developing a model in which bankers can privately undertake a costly effort and reduce the probability of adverse shocks to their asset holdings that force liquidation (deterioration risk). Low fundamental risk of assets guarantees benevolent funding conditions and banks are able to expand their balance sheets. The high continuation value would, in principle, improve incentives. However, the rise in asset demand and prices may jeopardize bankers' efforts whenever the liquidation price is high enough. This imposes socially inefficient liquidation which can be corrected with a capital requirement that aligns bankers' incentives. We show that a microprudential regulatory regime that disregards the equilibrium effect of asset prices on incentives performs poorly as low fundamental risk may induce high deterioration risk. Overall, the model suggests a theoretical foundation for the countercyclical capital buffer of Basel III, since it prescribes a macroprudential regulatory regime in which the equilibrium feedback effect is fully taken into account.

Keywords: macroprudential regulation, incentives, financial stability, Basel III, Value-at-Risk, market-based financial intermediaries, financial crises

JEL Classification: E44, D86, G18

Suggested Citation

di Iasio, Giovanni and Quagliariello, Mario, Incentives Through the Cycle: Microfounded Macroprudential Regulation (January 30, 2013). Bank of Italy Temi di Discussione (Working Paper) No. 894. Available at SSRN: https://ssrn.com/abstract=2221311 or http://dx.doi.org/10.2139/ssrn.2221311

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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