DP19532 A Macroeconomic Model of Banks' Systemic Risk Taking
We study banks' systemic risk-taking decisions in a dynamic general equilibrium model, highlighting the macroprudential role of bank capital requirements. Bankers decide on the unobservable exposure of their banks to systemic shocks by balancing risk-shifting gains against the value of preserving their capital after such shocks. Capital requirements reduce systemic risk taking but at the cost of reducing credit and output in calm times, generating welfare trade-offs. We find that systemic risk taking is maximal after long periods of calm and may worsen if capital requirements are countercyclically adjusted. Removing deposit insurance introduces market discipline but increases the bank capital necessary to support credit, implies lower (though far from zero) optimal capital requirements, and has nuanced social welfare effects.
