Why solvency regulation of banks fails to reach its objective

Peter Zweifel (), Dieter Pfaff () and Jochen Kühn
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Peter Zweifel: Department of Economics, University of Zurich
Dieter Pfaff: Department of Business Administration (IBW), University of Zurich

No 303, Working Papers from University of Zurich, Department of Business Administration (IBW)

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.

Keywords: regulation; banks; solvency; Basel I; Basel II; Basel III (search for similar items in EconPapers)
JEL-codes: G15 G21 G28 L51 (search for similar items in EconPapers)
Pages: 26 pages
Date: 2012-05
New Economics Papers: this item is included in nep-ban, nep-cba and nep-rmg
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Persistent link: https://EconPapers.repec.org/RePEc:zrh:wpaper:303

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