Publicly traded banks often face a no-win situation in the eyes of the stock market when trying to meet capital regulations, according to the Federal Reserve Bank of Atlanta.

Federal regulators in the 1990s have sharpened their sights on banking institutions' capital ratios as a way to prevent bank failures and reduce losses to the federal government when banks go under.

After reviewing numerous studies to determine banks' responses to capital regulations and the costs and benefits of these strategies, researchers at the Atlanta Fed found banks generally react in two basic ways.

Banks either make "cosmetic changes" to their capital ratio, such as reducing total assets while increasing the proportion of risky assets; or they increase their capital cushion by reducing risk exposure, restricting lending, or boosting capital levels, the study said.

Wall Street prefers banks to use operating profits to meet capital requirements. "Banks that must resort to accounting gimmicks or new capital issues are viewed as signaling weak future profitability, and their stock prices drop to reflect that adverse signal," the report said.

Such negative stock market response was consistently demonstrated, said Larry D. Wall, an Atlanta Fed research officer who co-authored the study, "Banks' Responses to Binding Regulatory Capital Requirements."

While not allowed under current capital rules, the study states banks could reduce their risk exposure by better diversifying their lending portfolio or hedging by employing instruments such as credit derivatives.

For instance, banks don't receive recognition for the risk reduction credit derivatives can accomplish, and these derivatives can increase capital requirements, Mr. Wall noted. However, changes measuring the diversification of lending risk is difficult, he said.

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