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The aim of the present paper is to assess the pro-cyclical impact of risk-sensitive bank capital. The authors develop a theoretical model where banks may apply two capital management rules: either keep a constant, time-invariant, capital to loan ratio for all loans ("Flat" capital ratio), or hold distinct, time-variant, capital to loan ratios depending on the measured riskiness of the loans ("Risk-based" capital ratio). Despite its inherent cyclicality they show that the risk-sensitive capital rule may work to stabilize banks' supply of credit over the business cycle when the credit market is characterised by over-investment, i.e. credit standards are loose and resources are inefficiently allocated to risky projects.
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