One of the key questions in considering capital requirements is what the incentive effects on banks will be and therefore how their behaviour will change with different modifications to the requirements. This paper examines the issue.
Several approaches to setting bank capital requirements are competing for policymakers’ favor: the current risk-weighted approach embedded in Basel III and variants; a leverage ratio; and the use of stress tests. In practice, as is currently true in the US, some combination of these will be used.
This paper answers the following questions:
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Why would banks change their behaviour based on capital requirements?
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What are the incentive effects which are desired by policymakers?
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How will banks decide how to respond to capital requirements?
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What are the likely effects of different capital regimes?
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How will multiple approaches interact when used together?
A key point of this paper is that the sophisticated banks that dominate the financial system will directly incorporate the effects of capital regimes into their internal pricing models. This will result in the incentive effects flowing directly through to almost all decisions about business mix and pricing. Thus, incentive effects will be much more than academic constructs, they will play through into actual business decisions via banks’ internal markets much as changes in monetary policy trigger substantial changes in market prices in the economy as a whole
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