THE REGULATION OF BANK CAPITAL - DO CAPITAL STANDARDS PROMOTE BANK SAFETY

We show that in an imperfect information environment the equity value of an impaired bank may increase or decrease when it is required to me et a capital standard. Regardless of the change in the bank's equity v alue, however, its stock price will fall in response to a forced recap italization, consistent with recent empirical evidence. Simulations of our model suggest that this stock price decline is likely to be large r the smaller is the share of ownership held by the managers of the ba nk, also consistent with recent empirical evidence in the literature. Our model further predicts a rise in bank's non-interest expenses foll owing a required recapitalization. Given the increase in the regulator 's exposure that would accompany a reduction in the bank's market valu e of equity, the regulator may choose not to enforce the regulation. H ence, capital regulation may be time-inconsistent in this situation an d consequently not have its intended risk-mitigating incentives. (C) 1 996 Academic Press, Inc.