Is regulating the solvency of banks counter-productive?

Peter Zweifel, Dieter Pfaff and Jochen Kühn
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Peter Zweifel: UWA Business School, The University of Western Australia
Dieter Pfaff: University of Zurich
Jochen Kühn: Volkenbachstr, Jestetten

No 09-16, Economics Discussion / Working Papers from The University of Western Australia, Department of Economics

Abstract: This paper contains a critique of solvency regulation such as imposed on banks by Basel I and II. It argues that banks seeking to maximize rate of return on risk-adjusted capital (RORAC) aim at an optimal level of solvency because on the one hand, solvency S lowers the cost of refinancing; on the other, it ties costly capital. In period 1, exogenous changes in mean returns dµ and in volatility occur, causing optimal adjustments dS * / dµ and dS * / ds in period 2. Since banks reallocate their assets with certain µ and s values in response to the changed solvency level, an endogenous trade-off with slope dµ / ds results in period 3. Both Basel I and II are shown to modify this slope, inducing at least some banks to opt for a higher value of s in certain situations. Therefore, this type of solvency regulation can prove counter-productive

Pages: 23 pages
Date: 2009
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Citations: View citations in EconPapers (1)

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Persistent link: https://EconPapers.repec.org/RePEc:uwa:wpaper:09-16

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