This paper investigates the effectiveness of capital requirements in reducing the default risk of portfolio-managing financial intermediaries. It is shown that the effectiveness depends, in essence, on the risk preferences of the intermediary and market conditions. The central result is that any binding capital requirement with risk weights not proportional to expected excess returns will prompt any sufficiently risk tolerant intermediary to increase default risk. The paper analyses the interplay between investment risk and default risk and identifies regulatory as well as market conditions under which financial intermediaries increase their default risk when facing binding capital requirements. It is shown how inappropriately chosen capital coefficients may increase rather than decrease the default risk of a financial intermediary.