08 August 2011

IMF published paper on Capital Regulation and Tail Risk

The IMF published a paper that studies risk mitigation associated with capital regulation, in a context where banks may choose tail risk assets. The paper finds that this approach undermines the traditional result that high capital reduces excess risk-taking driven by limited liability.

Moreover, higher capital may have an unintended effect of enabling banks to take more tail risk without the fear of breaching the minimal capital ratio in non-tail risky project realisations. It also finds that traditional buffer and incentives effects of capital become less powerful when banks have access to tail risk projects, as “left tails” limit the effectiveness of capital as the absorbing buffer and restrict “skin in the game” because a part of the loss is never borne by shareholders.

Working paper

© International Monetary Fund