The Compliance–Capital Adequacy Paradox under Exchange Rate Volatility: Evidence on Financial Risk-Taking and Firm Stability

This study investigates the compliance–capital adequacy paradox, a condition in which regulatory frameworks intended to strengthen banking stability inadvertently create incentives for greater financial risk-taking. Using panel data from commercial banks in Nigeria, Ghana, Kenya, and South Africa between 2013 and 2024, the research integrates econometric evidence with policy analysis to examine how compliance intensity interacts with capital adequacy in shaping banks’ risk behavior and stability. Employing fixed-effects regressions, the results show that higher capital adequacy ratios significantly reduce credit risk and enhance solvency, whereas increasing compliance costs compress profitability and encourage compensatory risk-taking. The positive interaction term between capital adequacy and compliance expenditure empirically confirms that excessive regulatory burdens can erode the stabilizing intent of prudential reforms. Furthermore, the results demonstrate that heightened exchange-rate fluctuations increase banks’ credit risk exposure. Cross-country analysis shows that governance standards, and supervisory capacity moderate this relationship, with stronger regulatory environments mitigating the paradox. Policy simulations further reveal an optimal equilibrium moderate capital threshold combined with proportional compliance intensity where solvency and financial intermediation remain jointly sustainable. By incorporating compliance costs and currency volatility into the capital adequacy models, the study contributes to the literature on prudential regulation and offers policy guidance for emerging markets on aligning regulatory design with institutional capacity. It concludes that enduring financial stability depends not only on stringent rules but also on context-sensitive and proportionate implementation.