Pillar 1 versus Pillar 2 under Risk Management

Loriana Pelizzon and Stephen Schaefer

in The Risks of Financial Institutions

Published by University of Chicago Press

Published in print February 2007 | ISBN: 9780226092850
Published online February 2013 | e-ISBN: 9780226092980 | DOI:
Pillar 1 versus Pillar 2 under Risk Management

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This chapter explores the consequences of adding Pillar 2 alongside Pillar 1 in terms of bank risk taking and the scale of bank lending. It also concentrates on the interaction between Pillar 1 and Pillar 2 when banks are able to use risk management to cheat in relation to capital requirements. The disciplinary effect of the franchise value vanishes when closure rules allow costless recapitalization. The presence of costs of recapitalization decreases the cost of deposit insurance but increases the probability of default. Without Pillar 2/Prompt Corrective Action (PCA), even when banks' compliance is relatively good (limited cheating), risk-based capital regulation (RBCR) may be effective in the sense that, for higher levels of RBCR, banks do indeed hold higher amounts of capital. Pillar 2/PCA is most effective in decreasing the cost of deposit insurance when compliance is relatively poor.

Keywords: Pillar 2; Pillar 1; bank risk; bank lending; risk management; capital requirements; recapitalization; capital regulation; deposit insurance; Prompt Corrective Action

Chapter.  16398 words.  Illustrated.

Subjects: Financial Markets

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