According to conventional wisdom in banking, a higher capital-asset ratio (CAR) is associated with a lower after-tax return on equity (ROE). The arguments in favor of this hypothesized negative relationship between capital and earnings have intuitive appeal and are consistent with standard one period models of perfect capital markets with symmetric information between a bank and its investors. A higher capital ratio tends to reduce the risk on equity and therefore lowers the equilibrium expected return on equity required by investors. In addition, a higher CAR lowers after-tax earnings by reducing the tax shield provided by the deductibility of interest payments. Moreover, the reduced risk from a higher capital ratio may depress earnings by lowering the value of access to federal deposit insurance that at best imperfectly prices risk.
Despite these arguments, the data on U.S. banks in the mid-to-late 1980s tell a very different story. Book values of CAR and ROE are positively related, and this relationship is both statistically and economically significant As shown below, the positive relationship between CAR and ROE holds both cross sectionally and for each year, holds when lags are included, and becomes even stronger when an extensive set of control variables is added to the regressions.
There are a number of potential explanations for the positive capital-earnings relationship, once the assumptions of the one-period model of perfect capital markets with symmetric information are relaxed. Relaxation of the one-period assumption allows an increase in earnings to raise the capital ratio, provided mat marginal earnings are not fully paid out in dividends. Relaxation of the perfect capital markets assumption allows an increase in capital to raise expected earnings by reducing the expected costs of bankruptcy or liquidation. Finally, relaxation of the symmetric information assumption allows for a signalling equilibrium in which banks that expect to have better performance credibly transmit this information through higher capital.
The purpose of this paper is to examine closely the capital-earnings relationship to try to determine which among the potential explanations of the relationship appear to be important We employ annual data 1983-1989 plus three years of lags on book values of capital, earnings, and a number of other variables obtained primarily from the Report of Condition and Income (Call Report). Available data for every insured U.S. commercial bank are used to the extent possible, yielding an unusually large data set of over 80,000 bank-year observations.
We regress CAR and ROE on three years of lagged CAR and ROE and a number of control variables, including dummies for every bank and time period in the sample. We find positive causation in the Granger sense to run in both directions between capital and earnings. The positive Granger-causality from earnings to capital is consistent with the hypothesis that banks retain some of their marginal earnings in the form of equity increases. This finding is not surprising.
We pay primary attention, however, to the positive Granger-causality from capital to earnings, which is quite surprising. This finding is also the most relevant to the public policy debate over appropriate capital standards, and the one which most directly challenges the conventional wisdom. Hie evidence suggests that higher capital is followed by higher earnings over the next few years primarily through reduced interest rates on uninsured purchased funds. These findings are strongest for banks with low capital and high portfolio risk who decreased their portfolio risks as well as increased their capital positions relative to what-they otherwise would have been. As discussed further below, these results are consistent with the hypothesis that, because of factors making banks riskier in the 1980s, some banks may have had greater than optimal risk of bankruptcy and the associated dead weight liquidation costs, and as a result paid very high risk premia on uninsured funds and suffered lower earnings. Those banks with increased expected bankruptcy costs that reacted by increasing capital quickly appear to have paid lower uninsured debt rates and had higher earnings than those that did not react in this way.
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The Relationship Between Capital and Earning in Banking
