A Simple Model of Bank Behaviour—With Implications for Solvency Regulation. (June 2015)

• Record Type: Journal Article
• Authors: Zweifel, Peter; Pfaff, Dieter; Kühn, Jochen
• Is Part Of: Studies in microeconomics. Volume 3:Number 1(2015:Jun.)
• Page Start: 49
• Page End: 68
• Publication Date: 2015-06
• Subjects: Regulation -- banks -- solvency -- Basel I -- Basel II -- Basel III; Microeconomics -- Periodicals; 338.505
• DOI: 10.1177/2321022215577549
• Languages: English
• ISSNs: 2321-0222

Abstract

A simple model of bank behaviour is shown to have implications for solvency regulation of the Basel type. The investment division seeks to maximize RORAC, with higher solvency S lowering the cost of refinancing but tying costly capital. In period 1, exogenous changes in expected returns d μ ¯ and in volatility d σ ¯ occur, causing optimal adjustments dS */ d μ ¯ and dS */ d σ ¯ in period 2. In period 3, the actual adjustment dS * creates an endogenous trade-off with slope d μ ^ / dσ ^ . Basel- type regulation modifies this slope, inducing senior management to opt for a higher value of σ in several situations. Solvency regulation can thus run counter its stated objective.