infonet-economy

This paper contains a critique of solvency regulation such as imposed on banks by Basel I and II. Banks’ investment divisions seek to maximize the expected rate of return on risk-adjusted capital (RORAC). For them, higher solvency S lowers the cost of refinancing but ties costly capital. Sequential decision making by banks is tracked over three periods. In period 1, exogenous changes in expected returns dμ and in volatility dσ occur, causing optimal adjustments dS* / dμ and dS * / dσ in period 2. In period 3, the actual adjustment dS* creates an endogenous trade-off with slope dμ / dσ. Both Basel I and II are shown to modify this slope, inducing top management to opt for a higher value of σ in several situations. Therefore, both types of solvency regulation can run counter their stated objective, which may also be true of Basel III.