Should Bank Capital Regulation Be Risk Sensitive?

Last updated: May 2020

We present a simple model of the risk sensitivity of bank capital regulation. A banker funds a project with uninsured deposits and costly capital, where capital resolves a moral hazard problem in the choice of the probability of default. Investors are uninformed about the project’s high or low loss given default, but a regulator receives a noisy signal and imposes minimum capital requirements. We show that the sensitivity of capital regulation to measured risk is non-monotonic. For an inaccurate signal, the regulator pools banker types via risk-insensitive capital requirements. For an accurate signal, the regulator separates types via risk-sensitive capital requirements. For an even more accurate signal, the risk sensitivity of bank capital requirements falls.