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Capital regulation and bank risk-taking: a note (reprinted from Journal of Banking and Finance)



Bconomic Review Federal Reserve Ba.n.k of San Francisco Summer 1991 Number 3 John P. Judd and Brian Motley Randall 1. Pozdena Frederick T. Furlong and Michael C. Keeley REM.INDER . our free st 15 deadline to contlllue.Y ec- If you missed the Augu our address label (wIth corr . t'on please send us Y subscnp I , tions) by October 1. Nominal Feedback Rules for Monetary Policy Why Banks Need Commerce Powers Can Bank Capital Regulation Work? • Capital Regulation and Bank Risk-Taking • A Reexamination of Mean-Variance Analysis of Bank Capital Regulation Capital Regulation and Bank Risk-Taking: A Note Frederick T. Furlong and Michael C. Keeley Federal Reserve Bank of San Francisco Reprinted from Journal ofBanking and Finance, 13(1989) by permission of Elsevier Science Publishers. This paper examines theoreticaUy the effects of more stringent capital regulation on bank asset portfolio risk. The analysis shows that, for a value-maximizing bank, incentives to increase asset risk decline as its capital increases. Thus, as long as regulatory efforts to contain asset risk and size are not reduced, more stringent capital regulation unambiguously reduces the expected liability of the deposit insurance system. 34 Concern over the risk exposure of the federal deposit insurance system has been a major factor behind the increase in capital standards in banking in the 1980s. A central issue in bank capital regulation is whether the enforcement of higher capital ratio requirements gives banks greater incentive to increase asset risk, thereby partially or even fully offsetting the effect of a higher capital ratio on default risk. Indeed a major criticism of the regulatory attempts to raise bank capital ratios in the 1980s is that these efforts "drove" banks to seek out more risky activities. This view that more stringent capital regulation will exacerbate the problem of risk-taking appears to be held widely among commercial bankers and is evident in the financial press as well as

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