The Capital Adequacy Directive (CAD) issued by the European Union (EU) and the ,,Bale Capital Accord to Cover Market Risk" (Basle Accord) issued by the Bank for International Settlements (BIS) limit banks' risk taking via a bound on the risk/equity ratio. Risk may either be calculated by in house models (value at-risk concepts) or by certain standard methods.
Normatively (if one accepts the axioms put forward by von Neumann/Morgenstem), banks make investment decisions such as to maximize expected utility. This implies a certain notion of risk. If the notion of risk underlying the regulation differs from that used by a bank in its investment decisions, adverse effects on a bank's risk taking may result from regulation, i.e. the regulatory limit might in some cases cause banks to take a riskier position than they would without any limit.
The risk measure prescribed for banks in their in-house models is value at risk (VaR). In a companion paper, we have shown that VaR may deliver a risk ranking that is not compatible with expected utility maximization. In this paper, we will show the implications of this result for banks' risk taking.
The paper is organized as follows: In Section 2 we will lay the foundations for decision making under uncertainty. Section 3 introduces the basic example used throughout the paper. As a reference situation we examine the asset allocation without any regulation in Section 4. There, we mention mean preserving spreads as a key concept to rank distributions according to riskiness. Section 5 is then devoted to asset allocation when the VaR is limited. After having discussed some practical problems of the VaR concept in Section 6, we turn to the lower partial moment one (LPM,) as an alternative to VaR (Section 7). Section 8 concludes by summing up main results and issues for further research.
