The Pre-Commitment Approach: Using Incentives to Set Market Risk Capital Requirements

Abstract

This paper develops a model of bank behavior that focuses on the interaction between the incentives created by fixed-rate deposit insurance and a bank's choice of its loan portfolio and its market-traded financial instruments. The model is used to analyze the consequences of the Federal Reserve Board's proposed pre-commitment approach (PCA) for setting market risk capital requirements for bank trading portfolios. Under the PCA, a bank determines its own market risk capital requirement and is subject to a known regulatory penalty should its trading activities generate subsequent losses that exceed its market risk capital commitment.