Risk Shifting with Fuzzy Capital Constraints

Simon Dubecq (1) , Benoit Mojon (2) , Xavier Ragot (3, 4)

1 Centre de recherche de la Banque Centrale européenne
2 Centre de recherche de la Banque de France
3 OFCE - Observatoire français des conjonctures économiques (Sciences Po)
4 ECON - Département d'économie (Sciences Po)

We construct a model where risk shifting can be moder-ated by capital requirements. Imperfect information about the level of capital per unit of risk, however, introduces uncertaintyabout the risk exposure of intermediaries. Over-estimation ofthe capital held by financial intermediaries, or the extent ofregulatory arbitrage, may induce households to wrongly infer from higher asset prices that the fundamentals of risky assets have improved. This mechanism can notably explain the lowrisk premia paid by U.S. financial intermediaries between 2000 and 2007 in spite of their increased exposure to risk through higher leverage. Moreover, the lower the level of the risk-free interest rate, the more risk is under-estimated

Keywords: Risk shifting; Capital requirements

Domains: Economics and Finance

Simon Dubecq, Benoit Mojon, Xavier Ragot. Risk Shifting with Fuzzy Capital Constraints. International Journal of Central Banking, 2015, 11 (1), pp.71 - 101. ⟨hal-03473718⟩