This paper investigates the role of bank capital regulation in risk control. It is known that banks choose portfolios of higher risk because of inefficiently priced deposit insurance. Bank capital regulation is a way to redress this bias toward risk. Utilizing the mean‐variance model, the following results are shown: (a) the use of simple capital ratios in regulation is an ineffective means to bound the insolvency risk of banks; (b) as a solution to problems of the capital ratio regulation, the “theoretically correct” risk weights under the risk‐based capital plan are explicitly derived; and (c) the “theoretically correct” risk weights are restrictions on asset composition, which alters the optimal portfolio choice of banking firms.
This paper presents evidence that the traditional banking business of accepting deposits and making loans has declined signi®cantly in the US in recent years. There has been a switch from directly held assets to pension funds and mutual funds. However, banks have maintained their position relative to GDP by innovating and switching from their traditional business to fee-producing activities. A comparison of investor portfolios across countries shows that households in the US and UK bear considerably more risk from their investments than counterparts in Japan, France and Germany. It is argued that in these latter countries intermediaries can manage risk by holding liquid reserves and intertemporally smoothing. However, in the US and UK competition from ®nancial markets prevents this and risk management must be accomplished using derivatives and other similar techniques. The decline in the traditional banking business and the ®nancial innovation undertaken by banks in the US is interpreted as a response to the competition from markets and the decline of intertemporal smoothing. Ó
JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact support@jstor.org. This content downloaded from 134. IntroductionRECENT LARGE BANK FAILURES (e.g., Franklin National), coupled with an unstable economic environment, have rekindled the controversy over the adequacy of bank capital. There is, of course, an abundance of literature on both sides of the bank capital issue. Noticeably absent from the literature arguing for and against regulating bank capital, however, is a detailed consideration of the impact of such regulation on individual bank behavior and whether the regulation actually achieves its desired result.' Typically regulation is assumed to function in an essentially ceteris paribus environment, whereby the mere addition of capital to the bank's balance sheet reduces risk. The purpose of this paper is to examine explicitly the issue of portfolio reaction to capital requirements by investigating the effect of capital ratio regulation on the portfolio behavior of commercial banks.2 Implicit in the analysis is the view that bank regulators presently do not constrain portfolio risk so as to prevent such asset reshuffling. Given the lack of objective standards or guidelines on asset portfolio risk, this approach seems more appropriate than to assume no asset portfolio response. This paper examines the portfolio allocation that flows from the portfolio decision of the firm. Next it examines the effects on bank portfolio risk of a regulatory increase in the minimum capital asset ratio that is acceptable to the supervisory agency. For the system as a whole, the results of a higher required capital-asset ratio in terms of the average probability of failure are ambiguous,3 while the intra-industry dispersion of the 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. Alternatively, regulation should be imposed on both asset composition and capital in a way that has heretofore not been considered. * Arthur D. Little, Inc. and The Wharton School, University of Pennsylvania, respectively. The authors would like to thank the Rodney L. White Center for Financial Research for financial assistance. Also, thanks go to Mark Flannery.' The only exception to this is a paper by Mingo and Wolkowitz [6]. However, this work neglects several essential features by assuming a linear utility function and a non-stochastic profit function. 2 We will assume that regulators can enforce capital requirements and that the measure of adequacy used is the capital-risk asset ratio. See Santomero and Watson [12] and Wolkowitz [13] for a discussion of capit...
scite is a Brooklyn-based organization that helps researchers better discover and understand research articles through Smart Citations–citations that display the context of the citation and describe whether the article provides supporting or contrasting evidence. scite is used by students and researchers from around the world and is funded in part by the National Science Foundation and the National Institute on Drug Abuse of the National Institutes of Health.
customersupport@researchsolutions.com
10624 S. Eastern Ave., Ste. A-614
Henderson, NV 89052, USA
Copyright © 2024 scite LLC. All rights reserved.
Made with 💙 for researchers
Part of the Research Solutions Family.