Risk-Shifting, Fuzzy Capital Constraint, and the Risk-Taking Channel of Monetary Policy

We construct a model where financial asset overpricing due to risk shifting can be moderated by capital requirements. Imperfect information about the level of capital per unit of risk, however, introduces uncertainty about the risk exposure of intermediaries. Overestimation of the level of capital of financial intermediaries, or the extent of regulatory arbitrage, may induce households to infer that higher asset prices are due to a decline of risk. This mechanism can explain the low risk premia paid by US financial intermediaries between 2000 and 2007 in spite of their increasing exposure to risk. Moreover, the underestimation of risk is larger the lower the level of the risk-free interest rate