Unintended consequences of the market risk requirement in banking regulation
We analyze a bank that operates under the Basel credit and market risk requirements, and that maximizes its value through recapitalizations, dividends, and liquid asset investments. According to our model, the market risk requirement may postpone recapitalization and this way increase the bank's default probability. We show that this is indeed the case if the expected return and volatility of the liquid asset portfolio are high, i.e., then the market risk requirement raises the default probability of the bank. In this sense the market risk requirement is inefficient.
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