Banking, Capital Regulation, Risk and Dynamics

Effects from risk, bankruptcies, and capital regulation of banks is explored in a dynamic stochastic equilibrium model where banks have two controls, dividends and level of risktaking. Unregulated value-maximizing banks, balance current profit against cost of risk. Banks with capitalization below desired level chose a lower level of risk than well-capitalized banks, but their capital adequacy ratios are yet lower. Binding regulation reduces risk-taking and instantaneous risk of bankruptcy but in the process also reduce endogenous growth of bank capital. This leads to an increased risk of bankruptcy that stems from the longer time banks spend poorly capitalized after large negative shocks due to the capital regulation.