Capital Regulation and Bank Risk Taking: Completing Blum’s Picture
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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- Kahane, Yehuda, 1977. "Capital adequacy and the regulation of financial intermediaries," Journal of Banking & Finance, Elsevier, vol. 1(2), pages 207-218, October.
- Frederick T. Furlong, 1988. "Changes in bank risk," FRBSF Economic Letter, Federal Reserve Bank of San Francisco, issue mar25.
- 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.
- Craig Furfine, 2001. "Bank Portfolio Allocation: The Impact of Capital Requirements, Regulatory Monitoring, and Economic Conditions," Journal of Financial Services Research, Springer;Western Finance Association, vol. 20(1), pages 33-56, September.
- Sudipto Bhattacharya & Manfred Plank & Josef Zechner & Gunter Strobl, 2000.
"Bank Capital Regulation With Random Audits,"
FMG Discussion Papers
dp354, Financial Markets Group.
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