Regulation and the Determination of Bank Capital Changes: A Note

The effectiveness of bank capital adequacy requirements is examined in this paper. Using empirical tests similar to those employed by Peltzman and Mingo, no significant relationship is found between changes in bank capital and the capital standards imposed by regulators. The findings conflict with those of previous studies. The conflict in findings, it is argued, results from the failure of previous studies to account for the effect of binding deposit rate ceilings. THIS PAPER REEXAMINES the question of whether bank capital adequacy standards formulated by the regulators have any effect on the capital decisions of commercial banks. Using a much larger sample of banks and a different time period than previous studies, we provide evidence that regulatory capital standards are not in general effective. Moreover, we suggest that the conflicting conclusions reached by previous studies concerning the influence of bank capital standards result from a failure to account for the influence of other bank regulations, particularly the effect of deposit interest rate ceilings. Bank capital serves two purposes; it is a source of funding and it is a residual capable of absorbing losses. These two functions of capital in banking do not differ qualitatively from the role of capital in a nonfinancial corporation. The incentives for equity financing in banking differ from the incentives to use equity in nonfinancial firms primarily because of deposit insurance. Deposit insurance transfers default risk from depositors to the insurer. As currently structured, deposit insurance premiums are insensitive to the risk assumed by the insurer, the Federal Deposit Insurance Corporation (FDIC). A conflict therefore arises between the level of equity desired by bank shareholders and the level desired by the FDIC. This conflict arises because, with complete insurance, additional equity reduces the contingent liability of the insurer, but does not reduce the cost of deposit financing through adjustments in deposit interest rates or through lower insurance premiums. The absence of these benefits causes a conflict between the bank shareholders and the deposit insurer and