Capital Requirements with Different Risky Assets

Abstract

History shows that prohibition diminishes the supply of capital and raises its returns. However, for value-added investors such as private equity investments, regulation potentially reduces capital quality. The regulatory measures introduced in Basel II Capital Framework and in the EU Capital requirements Directive (CRD) are meant to encourage more complete risk measurement and thus risk management, without reducing the competition. Basel III re-emphasizes a leverage ratio sort of rule. We focus on banks investing in buyouts; the main risk from these investments comes from the increased leverage. We use a structural and comprehensive model of the firm’s asset growth to describe buy-out portfolios’ stylized facts. The debt and equity are modeled as contingent claims on the assets. This method is more transparent and requires fewer parameters than other commonly used methods. The leverage ratio restriction balances between excess return of these investments and overall power of the supervisor enforcing the capital requirements; it is used to gauge the incentive of banks to carry the adequate amount of capital and enhances the supervisors’ ability to enforce the rules after the returns are realized.