Bank behaviour, financial fragility and prudential regulation

We develop a model of banking to show that financial fragility can emerge through banks optimal decision of profit maximisation even if banks meet the requirements laid down by the Basel II accord. Our results are twofold. First, we show that a risk sensitive micro prudential regulation, as the one of Basel II, cannot prevent the rise in financial fragility due to bank behaviour. In a period of expansion, characterized by assets bubble, bank optimal behaviour leads to an increase in leverage that induce a rise in financial fragility. Consequently, a constraint on a maximum leverage ratio seems to be justified if one wants to prevent financial fragility. This is the road follows by the new Basel III macro prudential regulation that wants to impose to bank a maximum leverage of 33. However, our second result stresses that the value of leverage that maximizes financial stability is not constant with the cycle. It means that the regulator must adjust this ratio in order for it to be efficient. Moreover, we show also that a restriction on leverage, that can improve financial stability, is detrimental to the level of financing in the economy. Consequently, there is a trade-off between financial stability and credit availability that must be considered by the regulation authority