The Impact of Capital-Based Regulation on Bank Risk-Taking: A Dynamic Model

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 suggests that the new regulatory environment may have the unintended consequence of inducing banks, especially undercapitalized ones, to invest in riskier assets. This holds both under higher capital requirements (even if risk-based) and under capital-based deposit-insurance premia.

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