Bank capital regulation as an incentive mechanism: Implications for portfolio choice

This paper contrasts the conventional interpretation of prudential capital regulation as a system of ex ante enforcement ('hard wired') with an alternative interpretation as a system of sanctions for ex post violation ('incentive based'). Under the incentive based interpretation risk-weightings affect portfolio choice only when assets are illiquid. Under both interpretations, the medium term impact on portfolio allocation depends upon (lie relative costs of debt and equity finance. Viewing enforcement as incentive based suggests (here is relatively less need to match risk weightings accurately to portfolio risk. (C) 2002 Elsevier Science B.V. All rights reserved.