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Bank capital regulation in a cap option framework

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  • Tsai, Jeng-Yan
  • Hung, Wei-Ming

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).

Suggested Citation

  • Tsai, Jeng-Yan & Hung, Wei-Ming, 2013. "Bank capital regulation in a cap option framework," International Review of Economics & Finance, Elsevier, vol. 25(C), pages 66-74.
  • Handle: RePEc:eee:reveco:v:25:y:2013:i:c:p:66-74
    DOI: 10.1016/j.iref.2012.05.002
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    References listed on IDEAS

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    Cited by:

    1. Chen, Shi & Chang, Chuen-Ping, 2015. "Should bank loan portfolio be diversified under government capital injection and deposit insurance fund protection?," International Review of Economics & Finance, Elsevier, vol. 38(C), pages 131-141.
    2. Lin, Kun-Li & Doan, Anh Tuan & Doong, Shuh-Chyi, 2016. "Changes in ownership structure and bank efficiency in Asian developing countries: The role of financial freedom," International Review of Economics & Finance, Elsevier, vol. 43(C), pages 19-34.
    3. Lin, Jyh-Horng & Tsai, Jeng-Yan & Hung, Wei-Ming, 2014. "Bank equity risk under bailout programs of loan guarantee and/or equity capital injection," International Review of Economics & Finance, Elsevier, vol. 31(C), pages 263-274.
    4. 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.
    5. Chen, Shi & Lin, Ku-Jun, 2015. "Technology choice and bank performance with government capital injection under deposit insurance fund protection," International Review of Economics & Finance, Elsevier, vol. 39(C), pages 162-174.
    6. Cui, Jin & In, Francis & Maharaj, Elizabeth Ann, 2016. "What drives the Libor–OIS spread? Evidence from five major currency Libor–OIS spreads," International Review of Economics & Finance, Elsevier, vol. 45(C), pages 358-375.

    More about this item

    Keywords

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

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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