Regulation of Bank Capital and Portfolio Risk

Michae Koehen and Anthony M. Santomero

Rodney L. White Center for Financial Research Working Papers from Wharton School Rodney L. White Center for Financial Research

Abstract: This paper examines the impact of bank portfolio behavior when banks are subject to capital regulation. It employs comparative static analysis of bank portfolio risk when regulators increase the minimum level of required capital relative to assets. The results show, under plausible assumptions that in increase in the required capital-asset ratio can lead to a higher portfolio risk and to a higher probability of failure. For the system as a whole, the results of a higher required capital-asset ratio in terms of the average probability o failure is ambiguous, while the intra-industry variance of probability of failure unambiguously increases. This result leads us to question the viability of regulating commercial banks in terms of a capital requirement. Thus, serious consideration should be given to the discontinuance of regulation of bank capital via ratio constraints and allowing the financial markets to control the risk behavior of bank management. Alternatively, such regulation should be imposed on a much more selective basis.

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