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Credit Risk and the Role of Capital Adequacy Regulation

Using the industrial organization approach to the microeconomics of banking we model a large (Monti-Klein) bank which is risk neutral and faces credit uncertainty in its loan business. The impact of capital adequacy regulation and the effect of changes in risk on deposit and loan rates are analyzed. We then show that capital adequacy regulation induces the bank to behave as if it were risk averse. Finally, we examine risk management with credit derivatives in the framework of the proposed New Basel Capital Accord where such hedging operations are explicitly accounted as reducing the risk position of a bank. In this environment separation and full hedge results are derived.

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File URL: http://www.wiwi.uni-augsburg.de/vwl/institut/paper/224.pdf
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Paper provided by Universitaet Augsburg, Institute for Economics in its series Discussion Paper Series with number 224.

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Length: pages
Date of creation: May 2002
Date of revision:
Handle: RePEc:aug:augsbe:0224
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Web page: http://www.wiwi.uni-augsburg.de/vwl/institut
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  1. Zarruk, Emilio R. & Madura, Jeff, 1992. "Optimal Bank Interest Margin under Capital Regulation and Deposit Insurance," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 27(01), pages 143-149, March.
  2. Sandmo, Agnar, 1971. "On the Theory of the Competitive Firm under Price Uncertainty," American Economic Review, American Economic Association, vol. 61(1), pages 65-73, March.
  3. Donald R. Lessard, 1995. "Financial Risk Management For Developing Countries: A Policy Overview," Journal of Applied Corporate Finance, Morgan Stanley, vol. 8(3), pages 4-18.
  4. Douglas W. Diamond & Raghuram G. Rajan, 2001. "Liquidity Risk, Liquidity Creation, and Financial Fragility: A Theory of Banking," Journal of Political Economy, University of Chicago Press, vol. 109(2), pages 287-327, April.
  5. Froot, Kenneth A. & Stein, Jeremy C., 1998. "Risk management, capital budgeting, and capital structure policy for financial institutions: an integrated approach," Journal of Financial Economics, Elsevier, vol. 47(1), pages 55-82, January.
  6. Rothschild, Michael & Stiglitz, Joseph E., 1970. "Increasing risk: I. A definition," Journal of Economic Theory, Elsevier, vol. 2(3), pages 225-243, September.
  7. Jensen, Michael C. & Meckling, William H., 1976. "Theory of the firm: Managerial behavior, agency costs and ownership structure," Journal of Financial Economics, Elsevier, vol. 3(4), pages 305-360, October.
  8. 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.
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