| dc.description.abstract | The focus of the present paper is the topic of financial stability and the effects of existing regulation mechanisms. Investment decisions made by financial institutions generate aggregate risk, which poses a threat of systemic collapse. Conceptually this process has been regarded as a negative externality. The present thesis explores to what extent the Basel III requirements provide optimal microprudential regulation and are able to secure financial stability. This is done by the means of a theoretical model representing an aggregation of banks that differ in their ability to handle risk, which cannot be improved upon. Each bank has a choice between safe and risky investments and has to make a decision on the proportion between the two alternatives in the asset portfolio. The risky asset generates a higher return, but increases the probability of going bankrupt for an individual bank. The aggregate amount of investment in the risky asset determines the level of systemic risk. At the same time banks may decrease the probability of going bankrupt by increasing the proportion of equity in the liability structure. However, this is associated with a cost, because investors demand a higher return on capital than on demand deposits. It is suggested that investors may pose market capital requirements : demand more equity if a bank increases the amount of risky investment. The problem is formalized mathematically as a Net Present Value function that each bank seeks to maximize. Given the model above, three different regulation mechanisms are considered with reference to the Basel III Accord: the liquidity ratio, risk-weighted capital requirements and the leverage ratio. The regulation alternatives are formulated mathematically and the problem is solved by the means of control theory, where the social planner finds an optimal path of liquidity and capital requirements. Specifically, it is shown that under perfect information Pareto optimality may be achieved with the help of a combination of liquidity regulation and risk-weighted capital requirements that both decrease in risk handling ability. In other words, banks that are good at risk handling are allowed to hold less liquidity and less capital as a fraction of their assets and liabilities respectively. Under asymmetric information, however, financial institutions that are bad at risk handling acquire incentives to mimic institutions that are good at risk handling in order to increase their revenues and save on capital. Such incentives are strongest when liquidity regulation is used in a combination with either the leverage ratio or risk-weighted capital requirements that decrease in risk handling ability. In order to prevent excessive aggregate risk accumulation and secure financial stability, the regulators may choose to equalize liquidity requirements for banks with different risk handling ability and use the latter in a combination with the leverage ratio. This results in inefficient risk sharing, suboptimal liquidity and capital buffers, at least for some banks. Alternatively, the regulators may choose to use liquidity requirements that decrease in risk handling ability in a combination with equal capital requirements for all banks. Depending on the strictness of the latter this may result in suboptimal liquidity and capital buffers, inefficient risk sharing or contribute to general underinvestment. The thesis thus shows that when the main source of heterogeneity across financial institutions is the ability to handle risk, the existing regulation requirements cannot achieve the first-best solution. In particular, they always produce suboptimal capital and/or liquidity buffers, at least for some banks. This is because financial stability is secured through what is known as bunching : treating different financial institutions alike. Since the latest Basel Accords are expected to be fully implemented in 2018, the predictions of the model are compared to the currently observed trends in the financial sector. Specifically, it has been noted that because of stricter risk-weighted capital requirements introduced by Basel III, banks have started a process of derisking of their assets. This might be an indicator of movement towards greater financial stability. At the same time concerns have been expressed as to whether financial activity may be simply migrating to the unregulated non-bank sector. Moreover, it is debated whether risk-weighted capital requirements introduced by Basel III are strict enough and will be able to combat excessive risk taking. Finally, it is uncertain whether Basel III has succeeded in providing incentives for truthful revelation of information. As long as banks have mimicking incentives, they will try to use any kind of cosmetic adjustments in order to maximize their profits at the cost of financial stability, which has been illustrated by the present thesis. | eng |