Incentives through the cycle: microfounded macroprudential regulation

Following a decline in the fundamental risk of assets, the ability of banks to expand the balance sheet under a Value-at-Risk constraint in- creases (as in Adrian and Shin (2010)), boosting the bank’s incentives to provide costly monitoring effort that prevents asset deterioration. On the other hand, high asset demand and prices, eventually, raise the bank’s pay- off in the event of liquidation associated to asset deterioration, jeopardiz- ing incentives. This paper shows that a microprudential regulatory regime that disregards the equilibrium effect of macro variables (asset prices) on micro behavior (effort), performs poorly as low fundamental (exogenous) risk reduces bank’s effort and induces high (endogenous) deterioration risk. This analysis calls for a macroprudential regulatory regime in which the equilibrium feedback effect is fully taken into account by the author- ity in designing incentive compatible capital requirements, providing a theoretical foundation to the countercyclical buffer of Basel III.