CAPITAL REQUIREMENTS AND THE BEHAVIOR OF COMMERCIAL-BANKS

I study the consequences of capital regulations on the portfolio choices of commercial banks. Elaborating on previous work by Kareken and Wallace (1978), Koehn and Santomero (1980) and Kim and Santomero (1988), 1 obtain the following results: -If the objective of commercial banks is maximization of the market value of their future profits (value maximizing banks), capital regulations cannot prevent banks from choosing very specialized and very risky portfolios. Risk-based insurance premia are in fact the relevant instrument for that purpose. -On the other hand, if banks behave as portfolio managers (utility maximizing banks) capital regulations can be effective, but only if the weights used in the computation of the ratio are proportional to the systematic risks of the assets (their betas). -Because of limited liability of commercial banks, a minimum capital regulation or a closing rule may become necessary as well to prevent failing banks from 'betting for resurrection'.