Reference no: EM133205336

Traditional finance theory states that "the higher the risk the higher the return it should generate" (Hillier et al., 2018). However, the current regulatory regime is aimed at reducing systemic risk but financial institutions, especially banks, take risks every time they lend money. The higher the risk profile on a bank's balance sheet the more capital it needs to have in order to support this risk. This is a means of controlling the number of risky loans a bank has in its portfolio and reducing the potential of bank failure and the contagion effect this can create. Some bank analysts believe that the regulatory system has contributed to the banks operating in a sub-optimal manner by focusing only on quality loans that produce safe but not high returns, rather than high risk loans which may, by their very nature, be for new ventures or expanding and developing entrepreneurial activity, both of which could be risky.

Critically review the current regulatory regime that banks work under and show how banks can attempt to maximise their profits whilst operating under these regulatory constraints.