Capital regulation and tail risk

The paper studies risk mitigation associated with capital regulation, in a context when banks may choose tail risk assets. We show that this undermines the traditional result that higher capital reduces excess risk-taking driven by limited liability. When capital raising is costly, poorly capitalized banks may limit risk to avoid breaching the minimal capital ratio. A bank with higher capital has less chance of breaching the ratio, so may actually take more risk. As a result, banks which have access to tail risk projects may take greater risk when highly capitalized. The results are consistent with stylized facts about pre-crisis bank behavior, and suggest implications for the optimal design of capital regulation

Collective strategic defaults: Bailouts and repayment incentives

This paper shows that under a global games approach banks may be subject to risk of failure even when fundamentals are strong due to a coordination problem among debtors. As a result of collective strategic default a financially sound firm may claim inability to repay if it expects a sufficient number of other firms to do so as well, thus reducing bank's enforcement ability. This occurs in particular when financial environment is characterized by inadequate bankruptcy laws and poor quality of corporate sector. The paper provides a model in which participants take simultaneous actions on the basis of imprecise private signals about the ratio of bad loans in bank portfolio. The model has a unique equilibrium in which an attack against the bank occurs when its fundamentals are above some threshold level. The model also helps us understand the role of the Central Bank as a Lender of Last Resort under opportunistic behavior from borrowers. While an ex-post bailout policy is often believed to reduce bank incentives, in this case it induces commercial banks to affect loan quality, which indirectly reduces incentives for strategic default. Within this framework we argue that the marginal cost of intervention incurred by Central Bank has a double-edge effect. While a higher cost helps to mitigate the moral hazard problem at the bank level by determining it to exert maximum of effort even when fundamentals are strong, it also increase the probability of bank failure by lowering the threshold in fundamentals that triggers collective strategic default. We also find that high bank expected profitability reduces the likelihood of collective strategic default

Strategic loan defaults and coordination:An experimental analysis

This paper experimentally studies the impact of bank and borrower fundamentals on loan repayment. We find that solvent borrowers are more likely to default strategically when the bank’s expected strength is low, although loan repayment is a Pareto dominant Nash equilibrium. Borrowers are also less likely to repay when other borrowers’ expected repayment capacity is low, regardless of banks’ fundamentals. We show that changes in expectations about bank and borrower fundamentals change the risk dominance properties of the borrowers’ coordination problem, and that these changes subsequently explain strategic defaults. For the individual borrower, loss aversion and negative past experiences reduce repayment, suggesting that bank failure can be contagious in times of distress