Internal Model-Based Capital Regulation and Bank Risk-Taking Incentives

Abstract

Bank capital requirements set by rigid rules are being replaced by more flexible requirements based on the bank’s internal risk model. But when the government creates a “safety net” for depositors, in the form of a guaranteed payoff on their accounts in the case of bank failure, or an implicit commitment not to allow a bank to fail, it effectively gives the bank a subsidy for taking risk. Since the bank does not have to pay depositors a risk premium for bearing default risk, it can earn a higher return on its risky investments, and will naturally tend to hold riskier assets and less capital. Kupiec sets out the problem explicitly and analyzes it in this article.