Risk-Taking and Solvency Regulation in Banking – A Note –

In a dynamic setting intertemporal effects can arise that render capital rules in banking as advocated by the Basel Committee of Banking Supervision counterproductive. It is quite possible that the banks' desire for excessive risk-taking is being reinforced by a binding capital rule such as the Basel risk-based capital requirement. In this paper an attempt is made to explore the impact of the so-called precommitment approach, proposed as an alternative to risk-based minimum capital rules, on the risk-taking behavior of banks. According to this proposal banks are free to self-assess their maximum possible losses, but make a commitment to the regulator to hold at least as much capital as is needed to cover these losses. It turns out that in a standard dynamic setting the precommitment approach is superior to the prevailing minimum capital rule in that the risk-neutral bank which maximizes its expected value of equity subject to a precommitted liquidity constraint chooses a risk-level which is socially optimal.