Larry D. Wall and Pamela P. Peterson
Economic Review, Vol. 81, No. 2, 1996

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Since the early 1980s U.S. bank regulators have focused increasingly on the adequacy of banks' capital ratios. This article begins with a review of the changes to U.S. capital regulations and theoretical models for determining banks' capital strategy. The authors then survey numerous studies that examine banks' responses, and the costs associated with their responses, to these regulations.

The authors categorize banks' responses into two primary types. The first of these, termed cosmetic changes to the capital ratio, may be achieved in one of two ways: a bank may reduce its total assets while increasing the proportion of risky assets, or it may exploit differences between capital as measured for regulatory purposes and the bank's true economic capital. Such cosmetic changes may bring a bank's capital ratio within regulatory guidelines without reducing either the probability that the bank will fail or the losses to depositors and the deposit insurance agency if the bank fails. The second general type of response a bank may make to capital regulation is to effectively increase its capital cushion by either reducing its risk exposure or increasing its capital levels.

The authors point out that regulators need to consider what response they want to elicit when formulating new regulations. If the regulations are being imposed to reduce the risk of a systemic problem and the expected losses of the deposit insurance agency, then regulations that encourage cosmetic responses are, by definition, unlikely to accomplish regulatory goals. The authors also note that the best way to reduce a bank's riskiness in many cases—diversification and hedging—is not adequately recognized under current capital standards.

March/April 1996