provisions while, in period of downturns, they become more worried and may ask for remedial actions which, from a macroprudential perspective, may make things worse.

When the cycle is driven by the cost of financing, instead, risk taking tends to be procyclical. The reason is that, as Dell’Ariccia et al. (2014) show in a recent paper, easy financing conditions (low interest rates) reduce the benefits of holding capital (to reduce the agency problems associated with limited liabilities) and thus foster higher leverage and additional risk taking. While this is true when banks optimally choose their capital level,<sup>40</sup> if banks are undercapitalized, the risk shifting channel becomes predominant and the classical Stiglitz and Weiss’ (1981) result that high interest rates lead to riskier behavior may still hold true. While macro and microprudential policies may go hand in hand when the cycle is driven by the interest rate, this “synchronicity” is more likely if banks are well capitalized. In situations in which leverage is substantial, for instance because of implicit bailout guarantees, conflicts between the macro and micro policy stance may instead still arise.

The next step is to look at the effects of different macroprudential instruments on banks’ risk taking incentives. Of course, the tightening of macroprudential regulation—through an increase in minimum capital requirements, RR, or taxes on credit—leads to a reduction in credit volumes. However, while an increase in capital requirements decreases the riskiness of the banks’ loan portfolio, an increase in RR or taxes on credit is likely to increase it.

How does this happen? The reason is that an increase in the banks’ external cost of funding, driven by an increase in RR, affects the banks’ bottom line only in those states of the world in which the bank actually repays its debt, that is, when it does not fail. This means that higher RR reduce the banks’ returns in the case of success and thus make banks less willing to put an additional effort to improve the quality of their portfolio. In other words, higher RR tend to exacerbate moral hazard and to induce banks to behave in a less prudent way. The idea that RR have a negative effect on the risk taking incentives of banks is not new to policy makers. Indeed, Aldo Mendes, the Brazil Central Bank’s director responsible for monetary policy, recently stated that “lowering reserve requirements helps financial stability.”<sup>41</sup> The practical argument, highlighted in a recent IMF (2012) report, is that “unlike an increase in capital requirements, an increase in RRs has no impact on the resilience of the banking system to loan losses [...] When RRs squeeze profitability, this can lead banks to shift into higher margin, but higher risk segments, in an effort to restore return on equity” (p. 15). As an example, the report mentions the unwanted consequences (on risk taking) of Turkey’s aggressive RR increase in early 2011.

Notice that even with the absence of deposit insurance, that is, when banks have an incentive to raise additional capital to reduce their cost of funding, they will nonetheless be prone to take on excessive risk (as compared to the social optimal levels) as long as they cannot credibly commit to a given level of portfolio risk. Of course, if the regulator has to act on behalf of less sophisticated (small) depositors and/or the deposit insurer, then it will have to further tighten prudential norms and raise capital requirements to re-equilibrate the incentives that were

> 40This effect is present independently of the presence of a deposit guarantee, but is magnified if the latter is in place.

> 41Bloomberg, September 20, 2012.

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