The Effect of Stricter Capital Regulation on Banks' Risk‐Taking: Theory and Evidence

A simple portfolio choice model shows that, when a bank's capital is constrained by regulation, regulatory cost (risk weightings) alters the risk and value calculations for the bank's assets. In particular, we find that banks may respond to stricter regulation by increasing the share of high‐risk assets. Our empirical results show that U.S. banks responded to the implementation of the stricter Basel II regulations by increasing the share of high‐risk assets in the risky part of their portfolios.