No. 98 - Capital controls and bank regulation

Our objective in this paper has been to analyze the effects of more stringent capital controls on the behavior of a bank that maximizes shareholder value where there are deposit guarantees and imperfect regulatory control of the risk of the bank's assets. In contrast to earlier work, we have taken the view that loan evaluation costs and loan monitoring costs make bank loans intrinsically different from zero npv (net present value) investments (e.g. market securities). Using a model incorporating a loan cost function that is increasing and convex in the level of investment and asset risk, we have shown that there are plausible circumstances in which an increase in capital requirements will result in a decrease in the level of investment, but an offsetting increase in asset risk. We have also shown that the conditions leading to this perverse response by banks are more likely to prevail the lower the current capital requirement and the higher the level of asset risk that a bank currently has. Furthermore, there are circumstances in which the resulting increase in asset risk will result in an increase in the probability of default.