Journal of Banking and Finance 1 (1977) 207-218. © North-Holland Publishing Company CAPITAL ADEQUACY AND THE REGULATION OF FINANCIAL INTERMEDIARIES Yehuda KAHANE* School of Business, The Hebrew University, Jerusalem, Israel I. Introduction Financial intermediaries are subject to various forms of regulation, intended to ensure their solvency. Commonly, regulators seek to achieve this goal by imposing an upper bound on the intermediary's leverage (e.g. through the use of a minimum capital requirement). Another regulatory means is by constraining the composition of the intermediary's assets and liabilities portfolios. The main purpose of this note is to examine the effectiveness of such regulatory instruments in protecting the intermediary's solvency. The analysis is carried out by first examining the relationships between the intermediary's opportunity curve and the probability of ruin. In the second step, the effects of the regulatory practices on the firm's opportunity set, and through it on the probability o~" ruin, are discussed. A portfolio model, balancing the assets and liabilities o'f the intermediary is used in calculating the distribution of the return on equity. This single~period model follows recent developments in the economic literature-- especially Michaelsen and Goshay (1967), Krouse (1970), Parkin (!970, Haugen and Kroncke (1970), Pyle (1971), Hart and Jaffee (1974) and Kahane and Nye (1975). It will be shown that constraining the portfolio composition of the intermediary, per se, cannot generally be regarded as an effective means for bounding the firm's probability of ruin; nor can the minimum capital requirement, per se. However, the combination of these regulatory practices may reach the desired effect. 2. Ruin It is assumed that the purpose of the regulation of financial intermediaries is to constrain the probability of their ruin, 'Ruin' is defined as the situation whereby the firm's earnings fall below a certain level h. There is no clear definition for how low should the earnings be (i.e. how extreme should the loss be) before being *The paper was written while visiting at the University of Toronto. I am indebted to Professor David Nve for very helpful discussions on the subject.