Do Capital Adequacy Requirements Reduce Risks in Banking?

by Jürg Blum of the University of Freiburg

May 1999

Abstract: In a dynamic framework it is shown that capital adequacy rules may increase a bank's riskiness. In addition to the standard negative effect of rents on risk attitudes of banks a further intertemporal effect has to be considered. The intuition behind the result is that under binding capital requirements an additional unit of equity tomorrow is more valuable to a bank. If raising equity is excessively costly, the only possibility to increase equity tomorrow is to increase risk today.

JEL Classification: G21, G28.

Keywords: Capital adequacy rules, Banking regulation, Risk taking.

Published in: Journal of Banking & Finance, Vol. 23, No. 5, (May 1999), pp. 755-771.

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