Bank Capital and Incentives for Risk-Taking

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Abstract
We analyse the incentive impact of bank capital regulation in a model with endogenous capital, assuming regulators randomly audit banks and require undercapitalised banks either to bear the fixed cost of new issue or to liquidate. Forward looking banks with sufficient franchise value maintain a buffer of capital in excess of the regulatory minimum. In our dynamic setting we show, amongst other results: that incentives for risk taking depend upon this buffer of free capital, not the total level; and that the regulatory capital requirement has no long run effect on bank risk-taking.