International lending bank risk and capital regulation: focus versus diversification

This paper uses an option-based model to examine the relationships among capital regulation, bank risk, and the optimal international lending determination. An increase in the capital-to-deposits ratio decreases the bank's domestic lending and increases foreign lending when the bank realizes a relatively less risky state of the world. An increase in the bank's risk-taking incentive increases its domestic lending and decreases foreign lending when the bank realizes a relatively more risky state. Our findings provide alternative explanations concerning the effect of capital regulation on lending diversification and the effect of risktaking incentive on lending focus.