| Abstract: | The relationship between a bank's soundness and the set of factors evaluated by supervisory agencies is so complex that the regulation of certain factors might have unintended consequences. This paper demonstrates that, ceteris paribus, binding capital adequacy regulation in the presence of stochastic deposits both reduces the expected future value of a bank and increases the uncertainty of that bank's future value. The uncertainty conclusion is not inconsistent with the notion of a decrease in the probability of financial distress as equity is substituted for debt; it involves an altogether different uncertainty and one that has heretofore not been recognized in either the theory of the banking firm or the literature of capital adequacy. |
