Law of the Market, Generic Behavior of Capital and the Vicious Circle of Bank Capital Regulation
65 Pages Posted: 4 Dec 2006
Date Written: September 2006
Capital-assets ratio (CAR) of banks is uniquely determined by the ROA/ROE ratio. This is validated from a study of US banks for the period, 1935-2004. ROE was negatively related to CAR before introduction of capital regulation in US banks but the relationship has turned positive during post-regulation period due to arbitrary rise of capital ratio which increased the required ROE and consequently ROA. The unprecedented rise in ROA of US banks during post-regulation period has increased the risk of the system, which is now in the midst of a vicious circle of more capital - more ROE - more ROA - more risky assets and again more capital.
Keywords: Equity, Bank capital, Market Law, Capital regulation, Risk
JEL Classification: G18, G21, G28, G32
Suggested Citation: Suggested Citation