Since the first Basel capital accord in 1988, the prevailing approach to bank regulation has put capital at front and center: more capital should make banks better able to absorb losses with their own resources, without becoming insolvent or necessitating a bailout with public funds. In addition, by forcing bank owners to have some skin in the game, minimum capital requirements should curb incentives for excessive risk taking created by limited liability and amplified by deposit insurance and bailout expectations. Over the last 20 years, regulatory capital requirements have been refined and broadened to cover various types of risk, differentiate among asset classes of different risk, and allow for a menu of approaches to determine the risk weights to be applied to each asset category. In the process, the rules have become increasingly elaborate, reflecting the growing complexity of modern banking, but also the need to address ongoing efforts by regulated entities to circumvent the requirements through financial innovation.
While regulatory consensus has viewed capital as an essential tool to limit risk in banking, there has been less agreement among economic theorists. A number of theoretical models bear out the relationship posited by regulators that minimum capital requirements ameliorate the moral hazard created by deposit insurance (Furlong and Keeley, 1989; Keeley and Furlong, 1990; Rochet, 1992), but others find that such requirements, by reducing the charter value of banks, have the opposite effect (Koehn and Santomero, 1980; Kim and Santomero, 1988). Calem and Rob (1998) reconciles these different views: in a dynamic model in which banks build up capital through retained earnings, this paper shows that when capital is low relative to the regulatory minimum banks choose a very risky loan portfolio to maximize the option value of deposit insurance. As capital increases and future insolvency becomes less likely, on the other hand, incentives to take on risk are curbed by the desire to preserve the bank’s charter value. When banks are so well capitalized that insolvency is remote, an additional increase in capital induces banks to take on more risk to benefit from the upside. In this model, the relationship between bank capital and risk is U-shaped.
The recent financial crisis undoubtedly demonstrated that existing capital regulation, in its design or implementation, was inadequate to prevent a panic in the financial sector, and once again governments around the world had to step in with emergency support to prevent a collapse. Many of the banks that were rescued appeared to be in compliance with minimum capital requirements shortly before and even during the crisis. In the ensuing debate over how to strengthen regulation, capital continues to play an important role. A consensus is being forged around a new set of capital standards (Basel III), with the goal of making capital requirements more stringent.
In this paper we try to make a contribution to understanding the role of bank capital by studying whether banks that were better capitalized experienced a smaller decline in their stock market value during the financial crisis. If bank capital truly helps curbing bank risk-taking incentives and absorbing losses, we would expect that, when a large, unexpected negative shock to bank value materializes as was the case with the financial crisis that began in August 2007 – equity market participants would judge better capitalized banks to be in a better position to withstand the shock, and the stock price of these banks would not fall as much as that of poorly capitalized banks.
Contents
I. Introduction
II. Sample Selection, Data Description, And Empirical Model
III. The Results
IV. Conclusions
