Federal Reserve Bank of San Francisco
Working Papers in Applied Economic Theory
Bank capital regulation: a reconciliation of two viewpoints
There are two seemingly inconsistent strands of the finance literature regarding the effects of bank capital regulation. On the one hand, the value maximization literature implies that more stringent capital regulation will reduce the probability of bank failure and the risk exposure of the deposit insurance fund. On the other hand, the utility-maximization literature, using the Markowitz two-parameter portfolio model, concludes that more stringent capital regulation will increase asset risk and can increase the probability of bank failure. ; In this paper, we show that this seeming inconsistency stems from the inapplicability of the Markowitz model to bankruptcy situations and the neglect of the effect of the option value of deposit insurance on the bank's opportunity set. As a result, the models commonly used in the utility-maximization literature cannot be used to support their results.
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Michael C. Keeley & Frederick T. Furlong, Bank capital regulation: a reconciliation of two viewpoints, Working Papers in Applied Economic Theory 87-06, Federal Reserve Bank of San Francisco, 1987.
Keywords: Bank capital ; Risk ; Deposit insurance ; Bank failures
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