Capital Regulation, Bailout and Banking Asset Correlation

Abstract

We study the effect of capital regulation on banking asset correlation. Banks are more efficient users of banking assets. This implies that it may be ex post optimal to bail out a failed bank. We show, under Basel 1 capital regulation, that the financial regulator is committed to a mixed bailout strategy in the state of systemic failure, which reduces banks’ incentive to choose highly correlated assets. The mixed strategy is not creditable under mark-to-market capital regulation. In the subgame perfect equilibrium, banking asset correlation increases, resulting in a high probability of systemic failure. We then discuss social losses under different capital regulations.