The Impact of Capital-Based Regulation on Bank Risk-Taking

In this paper we model the dynamic portfolio choice problem facing banks, calibrate the model using empirical data from the banking industry for 1984-1993, and assess quantitatively the impact of recent regulatory developments related to bank capital. The model implies a U-shaped relationship between capital and risk-taking: As a bank's capital increases it first takes less risk, then more risk. A deposit insurance premium surcharge on undercapitalized banks induces them to take more risk. An increased capital requirement, whether flat or risk-based, tends to induce more risk-taking by ex-ante well-capitalized banks that comply with the new standard