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Is regulating the solvency of banks counter-productive?

Author

Listed:
  • Peter Zweifel

    (UWA Business School, The University of Western Australia)

  • Dieter Pfaff

    (University of Zurich)

  • Jochen Kühn

    (Volkenbachstr, Jestetten)

Abstract

This paper contains a critique of solvency regulation such as imposed on banks by Basel I and II. It argues that banks seeking to maximize rate of return on risk-adjusted capital (RORAC) aim at an optimal level of solvency because on the one hand, solvency S lowers the cost of refinancing; on the other, it ties costly capital. In period 1, exogenous changes in mean returns dµ and in volatility occur, causing optimal adjustments dS * / dµ and dS * / ds in period 2. Since banks reallocate their assets with certain µ and s values in response to the changed solvency level, an endogenous trade-off with slope dµ / ds results in period 3. Both Basel I and II are shown to modify this slope, inducing at least some banks to opt for a higher value of s in certain situations. Therefore, this type of solvency regulation can prove counter-productive

Suggested Citation

  • Peter Zweifel & Dieter Pfaff & Jochen Kühn, 2009. "Is regulating the solvency of banks counter-productive?," Economics Discussion / Working Papers 09-16, The University of Western Australia, Department of Economics.
    • Handle: RePEc:uwa:wpaper:09-16
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    File URL: https://www.business.uwa.edu.au/__data/assets/pdf_file/0019/402805/09_16_Zweifel.pdf
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    Cited by:

    1. Zhang, Dongyang & Zhuge, Liqun & Freeman, Richard B., 2020. "Firm dynamics of hi-tech start-ups: Does innovation matter?," China Economic Review, Elsevier, vol. 59(C).

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