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Why solvency regulation of banks fails to reach its objective

  • Peter Zweifel

    ()

    (Department of Economics, University of Zurich)

  • Dieter Pfaff

    ()

    (Department of Business Administration (IBW), University of Zurich)

  • Jochen Kühn
Registered author(s):

    This paper contains a critique of solvency regulation such as imposed on banks by Basel I and II. Banks investment divisions seek to maximize the expected rate of return on risk-adjusted capital. For them, a higher solvency level lowers the cost of refinancing but ties costly capital. Sequential decision making by banks is tracked over three periods. In period 1, exogenous changes in expected returns and volatility occur, causing a pair of optimal adjustments of solvency in period 2. In period 3, the actual adjustment of solvency constitutes an exogenous shock, triggering portfolio adjustments in terms of expected return and volatility which move the bank along an endogenous efficiency frontier. Both Basel I and II are shown to modify the slope of this frontier, inducing senior management to opt for higher volatility in several situations. Therefore, both types of solvency regulation can run counter their stated objective, which may also be true of Basel III.

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    File URL: http://repec.business.uzh.ch/RePEc/zrh/wpaper/303_IBW_full.pdf
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    Paper provided by University of Zurich, Department of Business Administration (IBW) in its series Working Papers with number 303.

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    Length: 26 pages
    Date of creation: May 2012
    Date of revision:
    Handle: RePEc:zrh:wpaper:303
    Contact details of provider: Web page: http://www.business.uzh.ch

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