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Capital Regulation and Bank Risk Taking: Completing Blum’s Picture

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  • Nancy Silva

Abstract

This paper studies the intertemporal effects that capital regulation has on curbing bank risk taking, using the seminal model proposed in Blum (1999). Threshold values of the requirement in each period, for which capital regulation start affecting bank risk taking decisions, are calculated. One main lesson from this exercise is that constant capital requirements (as considered in Basel I) are indeed capable of reducing risk taking below the unregulated solution, and can even achieve the zero bankruptcy cost, socially efficient level of risk. However, that might happen for very high levels of the requirement, and at the cost of reducing financial intermediation. A second important lesson is that as the dynamic of risk depends on these thresholds, and they in turn depend upon the initial equity of the bank; knowing the latter is essential for the regulator to determine the effectiveness of capital regulation. Additional market instruments and effective monitoring and supervision (as proposed in Basel II) could be helpful on this task.

Suggested Citation

  • Nancy Silva, 2007. "Capital Regulation and Bank Risk Taking: Completing Blum’s Picture," Working Papers Central Bank of Chile 416, Central Bank of Chile.
    • Handle: RePEc:chb:bcchwp:416
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    File URL: https://www.bcentral.cl/documents/33528/133326/DTBC_416.pdf
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    References listed on IDEAS

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    1. Bhattacharya, Sudipto & Plank, Manfred & Strobl, Gunter & Zechner, Josef, 2002. "Bank capital regulation with random audits," Journal of Economic Dynamics and Control, Elsevier, vol. 26(7-8), pages 1301-1321, July.
    2. Koehn, Michael & Santomero, Anthony M, 1980. "Regulation of Bank Capital and Portfolio Risk," Journal of Finance, American Finance Association, vol. 35(5), pages 1235-1244, December.
    3. repec:bla:jfinan:v:43:y:1988:i:5:p:1219-33 is not listed on IDEAS
    4. Craig Furfine, 2001. "Bank Portfolio Allocation: The Impact of Capital Requirements, Regulatory Monitoring, and Economic Conditions," Journal of Financial Services Research, Springer;Western Finance Association, vol. 20(1), pages 33-56, September.
    5. Kahane, Yehuda, 1977. "Capital adequacy and the regulation of financial intermediaries," Journal of Banking & Finance, Elsevier, vol. 1(2), pages 207-218, October.
    6. Blum, Jurg, 1999. "Do capital adequacy requirements reduce risks in banking?," Journal of Banking & Finance, Elsevier, vol. 23(5), pages 755-771, May.
    7. Jones, David, 2000. "Emerging problems with the Basel Capital Accord: Regulatory capital arbitrage and related issues," Journal of Banking & Finance, Elsevier, vol. 24(1-2), pages 35-58, January.
    8. Mayer,Colin & Vives,Xavier (ed.), 1993. "Capital Markets and Financial Intermediation," Cambridge Books, Cambridge University Press, number 9780521443975, November.
    9. Frederick T. Furlong, 1988. "Changes in bank risk," FRBSF Economic Letter, Federal Reserve Bank of San Francisco, issue mar25.
    10. Jean-Charles Rochet, 2004. "Rebalancing the three pillars of Basel II," Economic Policy Review, Federal Reserve Bank of New York, issue Sep, pages 7-21.
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    Cited by:

    1. Amel Belanes & Afef Ben Hajiba, 2012. "Regulation and risk taking in the banking industry: evidence from Tunisia," Afro-Asian Journal of Finance and Accounting, Inderscience Enterprises Ltd, vol. 3(1), pages 89-104.

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