Robust Capital Regulation

by Viral Acharya of New York University,
Hamid Mehran of Federal Reserve Bank of New York,
Til Schuermann of Oliver Wyman, and
Anjan Thakor of Washington University in St. Louis & European Corporate Governance Institute

January 2012

Abstract: Regulators and markets can find the balance sheets of large financial institutions difficult to penetrate, and they are mindful of how undercapitalization can create incentives to take on excessive risk. This study proposes a novel framework for capital regulation that addresses banks' incentives to take on excessive risk and leverage. The framework consists of a special capital account in addition to a core capital requirement. The special account would accrue to a bank's shareholders as long as the bank is solvent, but would pass to the bank's regulators—rather than its creditors—if the bank fails. By design, this special account thus limits risk taking, but ensures that creditors' disciplining incentives are preserved.

JEL Classification: G12, G21.

Keywords: capital requirements, leverage, market discipline, model risk, systemic risk.

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