JOURNAL OF FINANCIAL INTERMEDIATION 5, 160–183 (1996) ARTICLE NO. 0009 The Regulation of Bank Capital: Do Capital Standards Promote Bank Safety?* DAVID BESANKO J. L. Kellogg Graduate School of Management, Northwestern University, Evanston, Illinois 60208 AND GEORGE KANATAS Jones Graduate School of Administration, Rice University, Houston, Texas 77251 Received March 17, 1994 We show that in an imperfect information environment the equity value of an impaired bank may increase or decrease when it is required to meet a capital standard. Regardless of the change in the bank’s equity value, however, its stock price will fall in response to a forced recapitalization, consistent with recent empirical evidence. Simulations of our model suggest that this stock price decline is likely to be larger the smaller is the share of ownership held by the managers of the bank, also consistent with recent empirical evidence in the literature. Our model further predicts a rise in bank’s non-interest expenses following a required recapitalization. Given the increase in the regulator’s exposure that would accompany a reduction in the bank’s market value of equity, the regulator may choose not to enforce the regulation. Hence, capital regulation may be time- inconsistent in this situation and consequently not have its intended risk-mitigating incentives.  1996 Academic Press, Inc. I. INTRODUCTION While there has long been general agreement among financial economists of the need for a replacement of capital standards that are based on account- ing measures with ones that incorporate the true riskiness of bank portfolios, * An earlier version of this paper was entitled ‘‘The Regulation of Bank Capital: Time Consistency, Hedging, and Incentive Compatibility.’’ We thank Arnoud Boot, Mark Flannery, Ajay Sammet, and especially Anjan Thakor and two referees for useful comments, as well as participants at presentations at the 1991 Financial Management Association Meetings, Indiana University, and Suffolk University. 160 1042-9573/96 $18.00 Copyright  1996 by Academic Press, Inc. All rights of reproduction in any form reserved.