We show how banks' excessive risk-taking, stemming from informational asymmetries in loan markets, can lead to an excessive output loss when a recession starts. Risk-based capital requirements can alleviate the output loss by reducing excessive risk-taking in ‘normal' times. Model simulations...

We study the effects on credit allocation and bank stability of introducing a leverage ratio requirement (LRR) on top of risk-based capital requirements, as in Basel III. For the current 3% LRR, both low-risk and high-risk loan rates and volumes remain essentially unchanged, because banks...

The aim of the Internal Ratings Based Approach (IRBA) of Basel II was that capital suffices for unexpected losses with at least a 99.9% probability. However, because only a fraction of the required regulatory capital (a quarter to a half) had to be loss absorbing capital, the actual solvency...

Building on the work of Sorge and Virolainen (2006), we revisit the data on aggregate Finnish bank loan losses from the corporate sector, which covers the ‘Big Five' crisis in Finland in the early 1990s. Several extensions to the empirical model are considered. These extensions are then used...

Although beneficial allocational effects have been a central motivator for the Basel II capital adequacy reform, the interaction of these effects with Basel II's procyclical impact has been less discussed. In this paper, we investigate the effect of capital requirements on the allocation of...

Basel II framework requires banks to conduct stress tests on their potential future minimum capital requirements and consider 'at least the effect of mild recession scenarios'. We propose a stress testing framework for minimum capital requirements in which banks' corporate credit risks are...

We suggest a complementary tool for financial stability analysis based on stochastic simulation of a dynamic stochastic general equilibrium model (DSGE) of the macro economy. The paper relates to financial stability research in which financial aggregates crucial to financial stability are...

The solvency standards implicit in bank capital levels, as reported e.g. in Jackson et al. (2002), are much higher than those required for top ratings, if standard single period economic capital models are taken seriously. We explain this excess capital puzzle by forward looking rating targeting...

We derive a principal-agent model to analyze the effectiveness of bonus caps and deferrals in regulating banks' risk-taking. We calibrate the model to a sample of large US banks on the eve of the Global Financial Crisis and run counterfactual analyses of the potential effects of the...

We derive a principal-agent model to analyze the effectiveness of bonus caps and deferrals in regulating banks' risk-taking. We calibrate the model to a sample of large US banks on the eve of the Global Financial Crisis and run counterfactual analyses of the potential effects of the regulations....