Abstract

This paper examines the effects of capital regulation on the optimal bank interest margin with two related bank objectives of option-based equity return maximization and equity risk minimization. We find that an increase in the capital-to-deposits ratio decreases the optimal interest margin under the equity return maximization, but increases the margin under the equity risk minimization. The proposed Basel system as such enables the bank to be more prone to loan risk when the objective is the equity return maximization, thereby adversely affecting the stability of the banking system, but to be less prone to loan when the objective is the equity risk minimization, thereby substantially contributing the stability. As a consequence, we argue that the effect of capital requirements on the safety of the banking system depends on the selection of the alternative objectives by banks, contributing to the literature's conflicting conclusions about capital regulation's effects on bank behavior.

Key words: Bank interest margin, capital regulation, equity return maximization, equity risk minimization.