A simple model of bank behaviour is shown to have implications for solvency regulation of the Basel type. The investment division seeks to maximize RORAC, with higher solvency S lowering the cost of refinancing but tying costly capital. In period 1, exogenous changes in expected returns d and in volatility d occur, causing optimal adjustments dS*/d and dS*/ d in period 2. In period 3, the actual adjustment dS* creates an endogenous trade-off with slope d/d. Basel-type regulation modifies this slope, inducing senior management to opt for a higher value of σ in several situations. Solvency regulation can thus run counter its stated objective.
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