DETERMINING AN OPTIMAL CAPITAL STANDARD FOR THE BANKING INDUSTRY

DURING THE LAST CENTURY the expansion of this country's commercial banks has been financed with less and less capital relative to debt. While many bankers have delighted in the increased leverage that declining capital positions allowed them, some economists and most regulators regard this trend with considerable skepticism. These economists are concerned that lower capital may lead to more bank failures, jeopardizing the financial stability and the viability of the present monetary exchange system. They have proposed various plans to prevent economic loss to depositors in the event of bank failures, Mayer [1965], and to heighten awareness of potential failures, Cohen [1970]. Regulatory authorities are convinced that allowing bank capital positions to erode is neither safe nor proper, and they have resisted this trend. Supervisory authorities argue that additional restraints on capital adequacy are needed to protect the public's interest in the financial system. They contend that the losses sustained when a bank fails exceed the costs borne by investors in the bank's securities because of the public nature of its liabilities; see for example, Shay [1974] and Watson [1974].