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A Simple Model of Bank Behaviour—With Implications for Solvency Regulation

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  • Peter Zweifel
  • Dieter Pfaff
  • Jochen Kühn

Abstract

A simple model of bank behaviour is shown to have implications for solvency regulation of the Basel type. The investment division seeks to maximize RORAC , with higher solvency S lowering the cost of refinancing but tying costly capital. In period 1, exogenous changes in expected returns d μ ¯ and in volatility d σ ¯ occur, causing optimal adjustments dS */ d μ ¯ and dS */ d σ ¯ in period 2. In period 3, the actual adjustment dS * creates an endogenous trade-off with slope d μ ^ / d σ ^ . Basel- type regulation modifies this slope, inducing senior management to opt for a higher value of σ in several situations. Solvency regulation can thus run counter its stated objective.

Suggested Citation

  • Peter Zweifel & Dieter Pfaff & Jochen Kühn, 2015. "A Simple Model of Bank Behaviour—With Implications for Solvency Regulation," Studies in Microeconomics, , vol. 3(1), pages 49-68, June.
    • Handle: RePEc:sae:miceco:v:3:y:2015:i:1:p:49-68
    DOI: 10.1177/2321022215577549
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