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Capital Regulation and Bank Risk Taking: Completing Blum’s Picture

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  • Nancy Silva
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    Abstract

    This paper studies the intertemporal effects that capital regulation has on curbing bank risk taking, using the seminal model proposed in Blum (1999). Threshold values of the requirement in each period, for which capital regulation start affecting bank risk taking decisions, are calculated. One main lesson from this exercise is that constant capital requirements (as considered in Basel I) are indeed capable of reducing risk taking below the unregulated solution, and can even achieve the zero bankruptcy cost, socially efficient level of risk. However, that might happen for very high levels of the requirement, and at the cost of reducing financial intermediation. A second important lesson is that as the dynamic of risk depends on these thresholds, and they in turn depend upon the initial equity of the bank; knowing the latter is essential for the regulator to determine the effectiveness of capital regulation. Additional market instruments and effective monitoring and supervision (as proposed in Basel II) could be helpful on this task.

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    File URL: http://www.bcentral.cl/estudios/documentos-trabajo/pdf/dtbc416.pdf
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    Bibliographic Info

    Paper provided by Central Bank of Chile in its series Working Papers Central Bank of Chile with number 416.

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    Date of creation: Mar 2007
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    Handle: RePEc:chb:bcchwp:416

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    1. Keeley, Michael C. & Furlong, Frederick T., 1990. "A reexamination of mean-variance analysis of bank capital regulation," Journal of Banking & Finance, Elsevier, vol. 14(1), pages 69-84, March.
    2. Besanko, David & Kanatas, George, 1993. "Credit Market Equilibrium with Bank Monitoring and Moral Hazard," Review of Financial Studies, Society for Financial Studies, vol. 6(1), pages 213-32.
    3. Bhattacharya, Sudipto & Plank, Manfred & Strobl, Günter & Zechner, Josef, 2000. "Bank Capital Regulation with Random Audits," CEPR Discussion Papers 2597, C.E.P.R. Discussion Papers.
    4. Kim, Daesik & Santomero, Anthony M, 1988. " Risk in Banking and Capital Regulation," Journal of Finance, American Finance Association, vol. 43(5), pages 1219-33, December.
    5. Jones, David, 2000. "Emerging problems with the Basel Capital Accord: Regulatory capital arbitrage and related issues," Journal of Banking & Finance, Elsevier, vol. 24(1-2), pages 35-58, January.
    6. Santos, Joao A. C., 1999. "Bank capital and equity investment regulations," Journal of Banking & Finance, Elsevier, vol. 23(7), pages 1095-1120, July.
    7. Kareken, John H & Wallace, Neil, 1978. "Deposit Insurance and Bank Regulation: A Partial-Equilibrium Exposition," The Journal of Business, University of Chicago Press, vol. 51(3), pages 413-38, July.
    8. Décamps, Jean-Paul & Rochet, Jean-Charles & Roger, Benoît, 2003. "The Three Pillars of Basel II, Optimizing the Mix," IDEI Working Papers 179, Institut d'Économie Industrielle (IDEI), Toulouse.
    9. George Sheldon, 1996. "Capital Adequacy Rules and the Risk-Seeking Behavior of Banks: A Firm-Level Analysis," Swiss Journal of Economics and Statistics (SJES), Swiss Society of Economics and Statistics (SSES), vol. 132(IV), pages 709-734, December.
    10. Flannery, Mark J., 1989. "Capital regulation and insured banks choice of individual loan default risks," Journal of Monetary Economics, Elsevier, vol. 24(2), pages 235-258, September.
    11. Kahane, Yehuda, 1977. "Capital adequacy and the regulation of financial intermediaries," Journal of Banking & Finance, Elsevier, vol. 1(2), pages 207-218, October.
    12. Koehn, Michael & Santomero, Anthony M, 1980. " Regulation of Bank Capital and Portfolio Risk," Journal of Finance, American Finance Association, vol. 35(5), pages 1235-44, December.
    13. Jean-Charles Rochet, 2004. "Rebalancing the three pillars of Basel II," Economic Policy Review, Federal Reserve Bank of New York, issue Sep, pages 7-21.
    14. William F. Sharpe, 1977. "Bank Capital Adequacy, Deposit Insurance and Security Values, Part I," NBER Working Papers 0209, National Bureau of Economic Research, Inc.
    15. Frederick T. Furlong, 1988. "Changes in bank risk," FRBSF Economic Letter, Federal Reserve Bank of San Francisco, issue Mar 25.
    16. Blum, Jurg, 1999. "Do capital adequacy requirements reduce risks in banking?," Journal of Banking & Finance, Elsevier, vol. 23(5), pages 755-771, May.
    17. João A. C. Santos, 2000. "Bank capital regulation in contemporary banking theory: a review of the literature," BIS Working Papers 90, Bank for International Settlements.
    18. Rochet, Jean-Charles, 1992. "Capital requirements and the behaviour of commercial banks," European Economic Review, Elsevier, vol. 36(5), pages 1137-1170, June.
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