Unintended Consequences of the Market Risk Requirement in Banking Regulation

by Jussi Keppo of the University of Michigan,
Leonard Kofman of the Bank of Montreal, and
Xu Meng of the University of Michigan

May 2010

Abstract: We analyze a bank that operates under the Basel credit and market risk requirements, and that maximizes its value through recapitalizations, dividends, and liquid asset investments. According to our model, the market risk requirement may postpone recapitalization and this way increase the bank's default probability. We show that this is indeed the case if the expected return and volatility of the liquid asset portfolio are high, i.e., then the market risk requirement raises the default probability of the bank. In this sense the market risk requirement is inefficient.

JEL Classification: G32, G35.

Keywords: bank capital, dividends, capital issues, investment, bank regulation.

Published in: Journal of Economic Dynamics and Control, Vol. 34, No. 10, (October 2010), pp. 2192-2214.

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