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Department of Applied Finance and Actuarial Studies

Professor Peter Zweifel Seminar

Research Seminars - business and economics
  • Topic: Is regulating the solvency of banks counter-productive?
  • Speaker: Peter Zweifel, Professor of Economics, University of Zurich, Switzerland
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This paper contains a critique of solvency regulation as imposed on banks by Basel I and Basel II. Banks’ investment decisions seek to maximize the expected rate of return on risk-adjusted capital. For them, a higher solvency level lowers the cost of refinancing but ties costly capital. Sequential decision making by banks is tracked over three periods. In period 1, exogenous changes in expected returns and in volatility occur, causing an optimal adjustment of solvency in period 2. In period 3, the changed level of solvency acts like an exogenous shock, giving in turn rise to endogenous changes in expected returns and volatility and a trade-off between them. Both Basel I and Basel II are shown to modify this trade-off, inducing top management to opt for a higher volatility in several situations. Therefore, both types of solvency regulation can run counter their stated objective, which also may be true of Basel III.

This is joint work with Dieter Pfaff and Jochen Kuehn.


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