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Why solvency regulation of banks fails to reach its objective

Author

Listed:
  • Peter Zweifel

    () (Department of Economics, University of Zurich)

  • Dieter Pfaff

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

  • Jochen Kühn

Abstract

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.

Suggested Citation

  • Peter Zweifel & Dieter Pfaff & Jochen Kühn, 2012. "Why solvency regulation of banks fails to reach its objective," Working Papers 303, University of Zurich, Department of Business Administration (IBW).
  • Handle: RePEc:zrh:wpaper:303
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    File URL: http://repec.business.uzh.ch/RePEc/zrh/wpaper/303_IBW_full.pdf
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    References listed on IDEAS

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    More about this item

    Keywords

    regulation; banks; solvency; Basel I; Basel II; Basel III;

    JEL classification:

    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • L51 - Industrial Organization - - Regulation and Industrial Policy - - - Economics of Regulation

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