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Optimal bank interest margins under capital regulation in a call-option utility framework

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  • Tsai, Jeng-Yan
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    Abstract

    This paper examines the optimal bank interest margin under capital regulation when the bank's preference admits an additive call-option representation including both the like of higher equity return and the dislike of higher equity risk. In the call-option utility maximization, an increase in the capital requirement results in an increased amount of loans held by a bank at a reduced margin when loan quality is in distress. We also show that the impact on the bank interest margin from an increase in the capital requirement which ignores the dislike, that we call such behavior call-option equity maximization, leads to significant underestimation. Our results cast doubt on the effectiveness of capital regulation to exert a risk-reducing and return-increasing effect on the bank in particular where loan quality becomes worse, thereby adversely affecting the stability of the banking system.

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    Bibliographic Info

    Article provided by Elsevier in its journal Economic Modelling.

    Volume (Year): 31 (2013)
    Issue (Month): C ()
    Pages: 557-565

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    Handle: RePEc:eee:ecmode:v:31:y:2013:i:c:p:557-565

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    Web page: http://www.elsevier.com/locate/inca/30411

    Related research

    Keywords: Call-option utility maximization; Call-option equity maximization; Bank interest margins; Capital regulation;

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    Cited by:
    1. Chang, Chuen-Ping, 2014. "A barrier option framework for rescue package designs and bank default risks," Economic Modelling, Elsevier, vol. 38(C), pages 246-257.

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