Why solvency regulation of banks fails to reach its objective
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.
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Repullo, Rafael, 2004.
"Capital requirements, market power, and risk-taking in banking,"
Journal of Financial Intermediation,
Elsevier, vol. 13(2), pages 156-182, April.
- Rafael Repullo, 2002. "Capital requirements, market power, and risk-taking in banking," Proceedings 809, Federal Reserve Bank of Chicago.
- Repullo, Rafael, 2003. "Capital Requirements, Market Power and Risk-Taking in Banking," CEPR Discussion Papers 3721, C.E.P.R. Discussion Papers.
- Goldberg, Lawrence G. & Hudgins, Sylvia C., 2002. "Depositor discipline and changing strategies for regulating thrift institutions," Journal of Financial Economics, Elsevier, vol. 63(2), pages 263-274, February.
- Barro, Robert J, 1977.
"Unanticipated Money Growth and Unemployment in the United States,"
American Economic Review,
American Economic Association, vol. 67(2), pages 101-115, March.
- Robert J. Barro, 1976. "Unanticipated Money Growth and Unemployment in the United States," Working Papers 234, Queen's University, Department of Economics.
- Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
- Koehn, Michael & Santomero, Anthony M, 1980. " Regulation of Bank Capital and Portfolio Risk," Journal of Finance, American Finance Association, vol. 35(5), pages 1235-1244, December.
- Shrieves, Ronald E. & Dahl, Drew, 1992. "The relationship between risk and capital in commercial banks," Journal of Banking & Finance, Elsevier, vol. 16(2), pages 439-457, April.
- Merton, Robert C, 1974.
"On the Pricing of Corporate Debt: The Risk Structure of Interest Rates,"
Journal of Finance,
American Finance Association, vol. 29(2), pages 449-470, May.
- Merton, Robert C., 1973. "On the pricing of corporate debt: the risk structure of interest rates," Working papers 684-73., Massachusetts Institute of Technology (MIT), Sloan School of Management.
- Park, Sangkyun & Peristiani, Stavros, 1998. "Market Discipline by Thrift Depositors," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 30(3), pages 347-364, August.
- Milton Friedman, 1957. "A Theory of the Consumption Function," NBER Books, National Bureau of Economic Research, Inc, number frie57-1, December.
- John, Kose & Saunders, Anthony & Senbet, Lemma W, 2000. "A Theory of Bank Regulation and Management Compensation," Review of Financial Studies, Society for Financial Studies, vol. 13(1), pages 95-125.
- Kose John & Anthony Saunders & Lemma W. Senbet, 1996. "A Theory of Bank Regulation and Management Compensation," New York University, Leonard N. Stern School Finance Department Working Paper Seires 96-30, New York University, Leonard N. Stern School of Business-.
- Kose John & Anthony Saunders & Lemma W. Senbet, 1998. "A Theory of Bank Regulation and Management Compensation," New York University, Leonard N. Stern School Finance Department Working Paper Seires 98-043, New York University, Leonard N. Stern School of Business-.
- Bauer, Wolfgang & Ryser, Marc, 2004. "Risk management strategies for banks," Journal of Banking & Finance, Elsevier, vol. 28(2), pages 331-352, February.
- Milton Friedman, 1957. "Introduction to "A Theory of the Consumption Function"," NBER Chapters,in: A Theory of the Consumption Function, pages 1-6 National Bureau of Economic Research, Inc.
- 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.
- Jacklin, Charles J & Bhattacharya, Sudipto, 1988. "Distinguishing Panics and Information-Based Bank Runs: Welfare and Policy Implications," Journal of Political Economy, University of Chicago Press, vol. 96(3), pages 568-592, June.
- René M. Stulz, 1996. "Rethinking Risk Management," Journal of Applied Corporate Finance, Morgan Stanley, vol. 9(3), pages 8-25.
- Rochet, Jean-Charles, 1992. "Capital requirements and the behaviour of commercial banks," European Economic Review, Elsevier, vol. 36(5), pages 1137-1170, June.
- Philippe Artzner & Freddy Delbaen & Jean-Marc Eber & David Heath, 1999. "Coherent Measures of Risk," Mathematical Finance, Wiley Blackwell, vol. 9(3), pages 203-228.
- Furfine, Craig H, 2003. " Interbank Exposures: Quantifying the Risk of Contagion," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 35(1), pages 111-128, February. Full references (including those not matched with items on IDEAS)
When requesting a correction, please mention this item's handle: RePEc:zrh:wpaper:303. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Daniela Koller)
If references are entirely missing, you can add them using this form.