Abstract
We study the optimal bank interest margin and default risk under the capped ratio schedule of government capital instruments in the Basel III Capital Adequacy Accord and the Deposit Insurance Fund arrangement program. We show that an increase in the capped ratio (a decrease in the capped government capital injection) increases the default risk in the bank’s equity return at a reduced interest margin. Regulatory deposit insurance fund protection reinforces the reduced bank interest margin and the increased default risk. The capped ratio schedule as well as the fund protection program makes the bank more prone to loan risk-taking, thereby adversely affecting the stability of banking system. This paper suggests that the two means of government intervention in response to the recent financial crisis might be not appropriate for a bank in distress, particularly from the standpoint of bank failure.
Highlights
“At the Basel III meeting, the central bank’s governors agree
Such a schedule is called the capped ratio schedule of government capital instruments in the Basel III Capital Adequacy Accord (BCAA), which provides an opportunity to reexamine bank distress liquidity management related to the stability of the banking system
Hamilton (2013) reports that the reserve ratio is at 0.45 percent at the end of 2012 that the fund has much less than it required ratio of 1.35 percent of the deposits it insures and the Federal Deposit Insurance Corporation (FDIC) expects to reach goal by 2020
Summary
“At the Basel III meeting, the central bank’s governors agree. Government capital instruments that no longer quality as non-common equity Tier 1 or Tier 2 capital will be phased-out over a 10-year period beginning on January 1, 2013. Beginning in 2013, the recognition of these instruments as qualifying capital will be capped at 90% of the minimal amount of such instruments outstanding, with the cap declining by 10% in each subsequent year.” Eubanks (2010) Such a schedule is called the capped ratio schedule of government capital instruments in the Basel III Capital Adequacy Accord (BCAA), which provides an opportunity to reexamine bank distress liquidity management related to the stability of the banking system. The suggestion of Eubanks (2010) needs to be more nuanced due to our argument: regulatory insurance fund protection reinforces the effect of BCAA on the reduced interest margin and the increased default risk in the bank’s equity return. Basel III is not a treaty, but is a work in progress that is far from completion, and the regulatory authorities may modify the agreement to suit their financial regulatory structures
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