Pillar 1 vs. Pillar 2 Under Risk Management

42 Pages Posted: 7 Dec 2005 Last revised: 2 May 2012

See all articles by Stephen M. Schaefer

Stephen M. Schaefer

London Business School - Institute of Finance and Accounting

Loriana Pelizzon

Goethe University Frankfurt - Faculty of Economics and Business Administration; Goethe University Frankfurt - Research Center SAFE; Ca Foscari University of Venice

Multiple version iconThere are 2 versions of this paper

Date Written: October 2005

Abstract

Under the New Basel Accord bank capital adequacy rules (Pillar 1) are substantially revised but the introduction of two new "Pillars" is, perhaps, of even greater significance. This paper focuses on Pillar 2 which expands the range of instruments available to the regulator when intervening with banks that are capital inadequate and investigates the complementarity between Pillar 1 (risk-based capital requirements) and Pillar 2. In particular, the paper focuses on the role of closure rules when recapitalization is costly. In the model banks are able to manage their portfolios dynamically and their decisions on recapitalization and capital structure are determined endogenously. A feature of our approach is to consider the costs as well as the benefits of capital regulation and to accommodate the behavioral response of banks in terms of their portfolio strategy and capital structure. The paper argues that problems of capital adequacy are minor unless, in at least some states of the world, banks are able to violate the capital adequacy rules. The paper shows how the role of Pillar 2 depends on the effectiveness of capital regulation, i.e., the extent to which banks can "cheat".

Suggested Citation

Schaefer, Stephen M. and Pelizzon, Loriana, Pillar 1 vs. Pillar 2 Under Risk Management (October 2005). NBER Working Paper No. w11666. Available at SSRN: https://ssrn.com/abstract=819827

Stephen M. Schaefer

London Business School - Institute of Finance and Accounting ( email )

Sussex Place
Regent's Park
London NW1 4SA
United Kingdom
+44 171 706 6887 (Phone)
+44 171 724 3317 (Fax)

Loriana Pelizzon (Contact Author)

Goethe University Frankfurt - Faculty of Economics and Business Administration ( email )

Theodor-W.-Adorno-Platz 3
Frankfurt am Main, D-60323
Germany

Goethe University Frankfurt - Research Center SAFE ( email )

Theodor-W.-Adorno-Platz 3
Frankfurt am Main, 60323
Germany

HOME PAGE: http://www.safe-frankfurt.de

Ca Foscari University of Venice ( email )

Dorsoduro 3246
Venice, Veneto 30123
Italy

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