The Basel III Capital Adequacy Accord (BCAA) will cap government capital injections as qualifying capital at 90% of the nominal amount of such capital outstanding, beginning in 2013, and the cap will decline by 10% during each subsequent year (Eubanks, 2010); this cap is called a capped ratio schedule of government capital instruments. We add to the literature on government capital injections by providing an option-based illustration of how the capped ratio schedule can influence bank interest margins and failure probability. We show that a declining capped ratio increases a bank’s volume of lending at a reduced margin and further increases its default risk. The capped ratio schedule as such makes the bank less prudent and more prone to risk-taking, thereby adversely affecting the stability of the banking system. Our findings provide alternative explanations for criticisms of BCAA.
Journal of Applied Finance & Banking 3(1), pp.161-175