Abstract
A simple model of bank behaviour is shown to have implications for solvency regulation of the Basel type. The investment division seeks to maximize RORAC, with higher solvency S lowering the cost of refinancing but tying costly capital. In period 1, exogenous changes in expected returns d[Formula: see text] and in volatility d[Formula: see text] occur, causing optimal adjustments dS*/ d[Formula: see text] and dS*/ d[Formula: see text] in period 2. In period 3, the actual adjustment dS* creates an endogenous trade-off with slope d[Formula: see text]/ d[Formula: see text]. Basel-type regulation modifies this slope, inducing senior management to opt for a higher value of σ in several situations. Solvency regulation can thus run counter its stated objective.
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