We present a model in which flat (state-independent) capital requirements are undesirable because of shocks to bank capital. There is a rationale for countercyclical capital requirements that impose lower capital demands when aggregate bank capital is low. However, such capital requirements also have a cost as they increase systemic risk taking: by insulating banks against aggregate shocks (but not bank-specific ones), they create incentives to invest in correlated activities. As a result, the economy’s sensitivity to shocks increases and systemic crises can become more likely. Capital requirements that directly incentivize banks to become less correlated dominate countercyclical policies as they reduce both systemic risk-taking and cyclicality.

Additional Metadata
Keywords Systemic risk, Regulation, Countercylical capital requirements
JEL Financial Crises (jel G01), Banks; Other Depository Institutions; Mortgages (jel G21), Government Policy and Regulation (jel G28)
Persistent URL dx.doi.org/10.1093/rof/rfx001, hdl.handle.net/1765/115283
Journal Review of Finance (Print)
Horvath, B.L, & Wagner, W.B. (2018). The Disturbing Interaction between Countercyclical Capital Requirements and Systemic Risk. Review of Finance (Print). doi:10.1093/rof/rfx001