Is Regulating the Solvency of Banks Counter-Productive?

This paper contains a critique of solvency regulation such as imposed on banks by Basel I and II. It argues that banks seeking to maximize rate of return on risk-adjusted capital (RORAC) aim at an optimal level of solvency because on the one hand, solvency S lowers the cost of refinancing; on the other, it ties costly capital. In period 1, exogenous changes in mean returns dμ and in volatility occur, causing optimal adjustments dS * / dμ and dS * / ds in period 2. Since banks reallocate their assets with certain μ and s values in response to the changed solvency level, an endogenous trade-off with slope dμ / ds results in period 3. Both Basel I and II are shown to modify this slope, inducing at least some banks to opt for a higher value of s in certain situations. Therefore, this type of solvency regulation can prove counter-productive.