Optimal capital requirements with noisy signals on banking risk
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Optimal capital requirements with noisy signals on banking risk Kai Ding1
· Enoch Hill2
· David Perez-Reyna3
Received: 13 January 2020 / Accepted: 2 September 2020 © Springer-Verlag GmbH Germany, part of Springer Nature 2020
Abstract We analyze the optimal capital requirement in a model of banks with heterogeneous investment risks and asymmetric information. Asymmetric information prevents depositors from charging an actuarially fair interest rate and leads to crosssubsidization across banks. A leverage constraint reduces the investment of riskier banks, mitigating the pecuniary externality on deposit rates. When policymakers lack information about banking risk, the optimal leverage constraint is tighter than the firstbest leverage ratio. When policymakers observe a noisy signal of banking risk, the optimal signal-based leverage constraint is tighter when the signal has worse precision, rather than a larger level of expected risk. Keywords Capital requirements · Banking regulation · Asymmetric information JEL Classification G21 · G28
We thank Manuel Amador, Yuk-Shing Cheng, Kim-Sau Chung, Jed DeVaro, Tim Kehoe, Melody Lo, Fabrizio Perri, Terry Roe, Nicholas Yannelis, and two anonymous referees for their valuable comments, as well as the Workshop in International Trade and Development at the University of Minnesota. We are also grateful to conference participants at the annual meeting for the Society for the Advancement of Economic Theory, seminar participants at Universidad de los Andes, Hong Kong Baptist University and at Banco de la República Colombia.
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Kai Ding [email protected] Enoch Hill [email protected] David Perez-Reyna [email protected]
1
California State University, East Bay, 25800 Carlos Bee Blvd, Hayward, CA 94542, USA
2
Wheaton College, 501 College Avenue, Wheaton, IL 60187, USA
3
Universidad de los Andes, Calle 19A 1-37 Este, bloque W, Bogotá, DC, Colombia
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1 Introduction The 2008 recession is frequently referred to as a financial crisis caused in part by the excessive risk-taking of banks and other financial institutions. How best to regulate financial institutions has motivated various rounds of Basel Accords. The conventional wisdom of setting capital requirements for financial institutions is to base requirements on the risk of the underlying assets on their balance sheet (on Banking Supervision 2017). However, prior to the 2008 financial crisis, mortgagebacked securities were widely considered safer assets, consistently receiving the highest ratings from all three credit bureaus (Ashcraft et al. 2010). The financial crisis revealed that these beliefs were incorrect: the risk for these securities was systematically higher than originally thought. When financial institutions carry assets that are engineered in a complicated fashion, it is difficult for investors and policymakers to accurately assess the risk of these institutions. This motivates our paper, which explores the optimal capital requirement in an environment with various degrees
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