Pillar 1 vs. Pillar 2 Under Risk Management

Loriana Pelizzon, Stephen Schaefer

NBER Working Paper No. 11666
Issued in October 2005
NBER Program(s):Asset Pricing, Monetary Economics

Under the New Basel Accord bank capital adequacy rules (Pillar 1) are substantially revised but the introduction of two new "Pillars" is, perhaps, of even greater significance. This paper focuses on Pillar 2 which expands the range of instruments available to the regulator when intervening with banks that are capital inadequate and investigates the complementarity between Pillar 1 (risk-based capital requirements) and Pillar 2. In particular, the paper focuses on the role of closure rules when recapitalization is costly. In the model banks are able to manage their portfolios dynamically and their decisions on recapitalization and capital structure are determined endogenously. A feature of our approach is to consider the costs as well as the benefits of capital regulation and to accommodate the behavioral response of banks in terms of their portfolio strategy and capital structure. The paper argues that problems of capital adequacy are minor unless, in at least some states of the world, banks are able to violate the capital adequacy rules. The paper shows how the role of Pillar 2 depends on the effectiveness of capital regulation, i.e., the extent to which banks can "cheat".

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Document Object Identifier (DOI): 10.3386/w11666

Published: Loriana Pelizzon & Stephen Schaefer, 2007. "Pillar 1 versus Pillar 2 under Risk Management," NBER Chapters, in: The Risks of Financial Institutions, pages 377-416 National Bureau of Economic Research, Inc.

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