Bank Interest Margin and Default Risk under the Capped Schedule for Government Capital Injections in the Basel III Capital Adequacy Accord

Chuen-Ping Chang and Jeng-Yan Tsai

Journal of Applied Finance & Banking, 2013, vol. 3, issue 1, 11

Abstract: The Basel III Capital Adequacy Accord (BCAA) will cap government capital injections as qualifying capital at 90% of the nominal amount of such capital outstanding, beginning in 2013, and the cap will decline by 10% during each subsequent year (Eubanks, 2010); this cap is called a capped ratio schedule of government capital instruments. We add to the literature on government capital injections by providing an option-based illustration of how the capped ratio schedule can influence bank interest margins and failure probability. We show that a declining capped ratio increases a bank’s volume of lending at a reduced margin and further increases its default risk. The capped ratio schedule as such makes the bank less prudent and more prone to risk-taking, thereby adversely affecting the stability of the banking system. Our findings provide alternative explanations for criticisms of BCAA.

Date: 2013
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