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Bank capital regulation in a cap option framework

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  • Tsai, Jeng-Yan
  • Hung, Wei-Ming
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    Abstract

    Synergy-banking management under capital regulation is done through a gluing together of lending and deposit-taking. Under this viewpoint, we argue that the cap options theory of corporate security valuation can be applied to the contingent claims of the synergy-banking firm. The equity holders of the bank own a cap option on the bank equity return which can be considered against their expected investment opportunity costs captured by the cap rates. We show that an increase in the cap rate increases the risky loans held by the bank at a lower interest margin, and then increases the equity risk and the default risk of equity. An increase in the capital-to-deposits ratio decreases the risky loans held by the bank at an increased margin, and decreases the bank's equity risk and the default probability in the bank's equity. Capital regulation as such makes the bank more prudent and less prone to risk-taking, thereby contributing to the stability of the banking system. Our findings may support increased capital requirements in the spirit of the Dodd–Frank Act of the Basel Accord (Eubanks, 2010).

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    File URL: http://www.sciencedirect.com/science/article/pii/S105905601200038X
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    Bibliographic Info

    Article provided by Elsevier in its journal International Review of Economics & Finance.

    Volume (Year): 25 (2013)
    Issue (Month): C ()
    Pages: 66-74

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    Handle: RePEc:eee:reveco:v:25:y:2013:i:c:p:66-74

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    Web page: http://www.elsevier.com/locate/inca/620165

    Related research

    Keywords: Cap options; Capital regulation; Bank interest margin; Equity volatility; Default risk;

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    Cited by:
    1. Tsai, Jeng-Yan, 2013. "Optimal bank interest margins under capital regulation in a call-option utility framework," Economic Modelling, Elsevier, vol. 31(C), pages 557-565.

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