Unintended Consequences of the Market Risk Requirement in Banking Regulation

46 Pages Posted: 30 Mar 2007 Last revised: 29 Mar 2010

Jussi Keppo

National University of Singapore - NUS Business School

Leonard Kofman

Bank of Montreal

Xu Meng

University of Michigan at Ann Arbor - Department of Industrial and Operations Engineering

Date Written: March 26, 2010

Abstract

We analyze a bank that operates under the Basel credit and market risk requirements, and that maximizes its value through recapitalizations, dividends, and liquid asset investments. According to our model, the market risk requirement may postpone recapitalization and this way increase the bank’s default probability. We show that this is indeed the case if the expected return and volatility of the liquid asset portfolio are high, i.e., then the market risk requirement raises the default probability of the bank. In this sense the market risk requirement is inefficient.

Keywords: bank capital, dividends, capital issues, investment, bank regulation

JEL Classification: G32, G35

Suggested Citation

Keppo, Jussi and Kofman, Leonard and Meng, Xu, Unintended Consequences of the Market Risk Requirement in Banking Regulation (March 26, 2010). Available at SSRN: https://ssrn.com/abstract=974623 or http://dx.doi.org/10.2139/ssrn.974623

Jussi Keppo (Contact Author)

National University of Singapore - NUS Business School ( email )

1 Business Link
Singapore, 117592
Singapore

Leonard Kofman

Bank of Montreal ( email )

Ontario
Canada

Xu Meng

University of Michigan at Ann Arbor - Department of Industrial and Operations Engineering ( email )

1205 Beal Avenue
Ann Arbor, MI 48109
United States

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