Bank regulation, crisis risk, and investment incentives (with John Cochrane)

Standard analyses of optimal bank capital requirements used by policy makers effectively assume risk neutrality despite risk aversion being fundamental to the problem that they address. Moreover, by reducing the probability and severity of financial crises, greater bank capital affects stochastic discount factors and hence investment incentives. We show in a simple model how this effect is typically positive because investment incentives are usually stronger when crisis risk is reduced.