the role of capital in financial institutions

8/3/2019 The Role of Capital in Financial Institutions

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The Role of Capital in FinancialInstitutions

Working Paper 95-01

Allen N. BergerRichard J. Herring

Giorgio P. Szeg

Allen N. Berger is at the Board of Governors of the Federal Reserve System and the Wharton Financial Institutions Center, the

University of Pennsylvania. Richard J. Herring is at the Wharton Financial Institutions Center, the University of Pennsylvania. Giorgio

P. Szeg is at the Universit de Roma 'La Sapienza.' The opinions expressed do not necessarily reflect those of the Board of

Governors or its staff. The authors thank the Wharton Financial Institutions Center for sponsoring the conference on which the special

issue is based at the Wharton School, March 9-11, 1994. We also thank Sankar Acharya, Franklin Allen, Bob Avery, Mark Carey,

Doug Cook, Mark Flannery, Diana Hancock, Dave Jones, Myron Kwast, Jim O'Brien, Steve Pilloff, Tony Santomero, and Greg Udell

for helpful comments, Jalal Akhavien and Joe Scalise for excellent research assistance, Alpha Bauer, Terry DiNardo, and Debbie Tiller

for invaluable administrative work, and all of the conference participants for making the conference and special issue possible.

JEL classification codes: G21, G28, G32, E58, L89.

Key Words: bank, capital, regulation, securitization, credit crunch


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T h e R o l e o f C a p i t a l i n F i n a n c ia l I n s t i t u t i o n s

J a n u a r y 1995

Ab s t r a c t : This ar ticle examines th e role of capita l in financial instit ut ions -- why

it is importan t, h ow ma rket-genera ted capital 'requirement s' differ from regulatory

requirement s, an d the form th at r egulatory requirement s should take. Along the

way, we examine h istorical tr ends in ba nk capita l, problems in measu ring capital,

an d some possible un int ended consequences of capita l requ iremen ts. With in this

fra mework, we evalua te how the cont ribut ors t o th e special issue of th e same t itle

(JBF, April 1995) advance the literature and suggest topics for future research.


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I . I n t r o d u c t i o n

The point of depar tu re for a ll modern research on capital str ucture is the

Modiglian i-Miller (M&M, 1958) proposition t ha t in a frictionless world of full

informa tion an d complete ma rket s, a firm's capital str ucture can not affect its

value. This proposition cont ra sts sha rply with t he intu itive notion t ha t a firm with

risk-free debt could borrow at an interest ra te below th e required r etur n on equity,

redu cing its weighted a verage cost of financing an d increasin g its value by

substitu ting debt for equity. But t he powerful ar bitrage argum ents employed by

M&M demonst ra te t ha t mar ket pr ices will compen sat e for a ny levera ge decision by

th e firm. When leverage is higher, so are th e risks to sha reholders, increasing the

costs of equity just en ough so th at th e weight ed avera ge cost of financing rema ins

const an t. More genera l versions of M&M showed tha t th e same resu lt holds with

risky debt -- th e costs of both equity an d risky debt r espond so th at th e cost of

financing is indepen dent of leverage. The challenge to those who ha ve come after

M&M ha s been t o ident ify credible depar tu res from th is frictionless world, ana lyze

th e implicat ions of these depart ur es for `optimal' capita l stru ctur e, and test th ese

implicat ions a gainst th e empirical evidence.

This resea rch is of pa rt icula r r elevan ce for fina ncial inst itut ions becaus e

th ese instit ut ions lack a ny plau sible ra tionale in t he frictionless world of M&M.

Most of th e past research on fina ncial institu tions h as begun with a set of assum ed

imperfections, such a s t axes, costs of financial distress, t ra nsa ctions costs,

asymmet ric inform at ion, an d especially regula tion. Noneth eless, as Miller (1995)

ar gues below, these imperfections m ay not be importan t en ough t o overtur n t he


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M&M Pr oposition. In cont ra st, most of th e oth er papers in th is special issue ta ke

the view (implicitly or explicitly) that the deviations from M&M's frictionless world

ar e importan t, so th at financial institut ions ma y be able to enh an ce their ma rket

values by ta king on an `optimal' amoun t of leverage.

The pu rpose of th is int roductory art icle, an d indeed th is entire issue, is to

investigat e th e role of cap ita l for financial instit ut ions -- why it is importa nt , how

ma rket-genera ted capital `requirements' differ from r egulatory r equirements, a nd

th e form t ha t regulatory requirement s should take. In th e process, we examine the

hist ory of ban k capita l, discuss issu es involved in implement ing cap ita l

requirement s, ana lyze problems in m easur ing capita l, and investigat e some of th e

un int ended consequ ences of capita l requ iremen ts. We also point out how th e

ar ticles in th e special issue cont ribut e to this litera tu re, as well as suggest topics for

future research.

Most of th e an alysis focuses on commercial banks in th e Unit ed Sta tes,

alth ough m an y of th e ar gument s apply more broadly to oth er fina ncial institu tions

an d regulat ory systems. Ban ks serve as a useful focus for an alysis becau se man y of

th e frictions t ha t make capit al str uctu re relevan t -- costs of financial distr ess,

asymmet ric inform at ion, tr an sactions costs, and r egulat ion -- ha ve been carefully

stu died in the ban king literat ur e. Moreover, bank s play an importan t role in th e

global economy, and a re t he first cat egory of instit ut ions to be subject t o

intern at iona lly coordinat ed capita l regulation. Fina lly, bank s systemat ically ha ve

th e highest levera ge of firms in a ny indust ry, in sha rp cont ra st t o the implicat ions


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Because of space constraints we have been unable to include all of the important1

references on capital and we have focussed narrowly on capital without fully discussing

related issues such as deposit insurance pricing, optimal closure rules, and other means of

controlling risk.

The value of banks is defined as the sum of market values of equity and debt. For small,2

closely-held banks without actively traded shares, we define market value of equity as the

discounted

net present value of expected future cash flows to shareholders.

of th e M&M proposition, which predicts t ha t capita l stru ctur es should vary

ra ndomly across firms a nd indu stries. 1

I I. Wh y Do Ma r k e t s `R e q u ir e ' F in a n c ia l I n st it u t i on s To H old C a p it a l?

In th is section, we examine why m ar kets may en cour age or `require' bank s or

other firms to hold cert ain capita l rat ios in the absence of regula tory cap ital re-

quirem ent s. Regulat ory capita l requ iremen ts will be consider ed lat er. We follow

th e tra dition in t he ban king litera tu re of referring to the capital rat io as t he ra tio of

equity t o asset s, alth ough we will use other r egulat ory definitions below.

We begin by defining a ban k's mar ket capital `requirement' as t he capital

ra tio th at ma ximizes th e value of th e bank in th e absence of regulatory capita l

requirement s an d all the regulatory mecha nisms th at ar e used to enforce them), but

in th e presence of th e rest of th e regulatory structur e tha t pr otects the sa fety an d

soun dness of bank s. This mark et `requirement ', which ma y differ for each bank, is2

th e rat io towar d which ea ch ba nk would tend to move in t he long ru n in t he

absen ce of

regula tory capit al requirem ent s. This constr uct will be useful for examin ing

depart ur es from the conditions u nder wh ich M&M holds. Note th at un like regu-


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See Miller (1977) and DeAngelo and Masulis (1980) for detailed treatments of taxes.3

latory requirements, san ctions for depa rt ures from m ar ket capital `requirement s'

ar e two-sided in t he sense th at th e value of th e ban k will decline if it ha s e i t h e r too

little or t oo much capita l.

The search for a n optimal capital str ucture or ma rket capital `requirement'

begins with th e int roduction of imperfections int o the frictionless world of M&M.

We will first consider ta xes an d costs of financial distr ess, followed by t ra nsa ctions

costs an d asymmet ric inform at ion problems. These considerat ions apply quite

broadly to all firms. We th en consider a n a dditional imperfection th at is specific to

ban ks -- th e regula tory sa fety net, defined more fully below.

T a x e s a n d F i n a n c i a l Di st r e s s

Taxes and th e costs of financial distr ess were the first majo r frictions consider ed

in determining optimal capital rat ios. Sinc e inter est payment s are t ax deductible, but

dividends ar e not, substituting debt for equity enables firms to pass greater retu rn s

to inves tors by reducing payment s to th e government . Other th ings equal, owners

prefer t o fu nd the firm almost entirely with debt. But increasing leverage also3

incr ea ses th e risk of incurr ing the costs of financial distr ess (defined below). The

expected costs of financial distress increase as the capital ratio declines and the

pr obability of insolvency rises. The capit al rat io at which the ta x adva nt ages of

additional debt ar e just offset by the increase in th e ex pected costs of financial distr ess

determines the optimal capital structure or market capital `requirement' in the

presence of these two frictions.


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Financial distress occurs when th e ban k is expected t o have difficult y honoring

its commitments. Costs of financial dist res s include t he cost s of bank ru pt cy -- i.e., th e

costs of tr an sferr ing owner ship of th e firm from sha reh olders to creditors. Finan cial

distress costs also include the loss in value tha t ma y oc cur as a resu lt of the perception

th at bank ru ptcy may be imminen t -- even if ban kru ptcy may ultimat ely be avoided.

Talented employees may leave, suppliers may demand more timely payments,

revenues from credit-risk-sen sitive products such as long-ter m swaps an d gua ra nt ees

may decline, and con flicts of inter est bet ween shar eholders an d creditors ma y lead to

suboptimal operating, investment, and financing decisions (discussed more fully

below).

Finan cial d istress sh ould be distinguish ed from economic distr ess. The cost of

fina ncial d istress ma y be mea sur ed as th e additional loss from economic distr ess for

a leveraged bank versus an identical bank th at is un leveraged. When asset quality

deteriorates, both banks will experience economic distress, but the leveraged bank

experiences a greater loss of value because of the incre ased risk of bankr upt cy, great er

uncertain ty th at th e bank will honor its commitmen ts to oth er sta keholders, and t he

increasing costs of cont rolling conflicts of int erest between sh areh older s and creditors .

Research on th e costs of fina ncial an d economic distr ess in ba nk ing illust ra tes

the difficulty of separa ting thes e two types of cost s. For example, Ja mes (1991) foun d

tha t in FDIC-admin ister ed ban k failures, ban k assets lost an avera ge of 30% of book

value when sold, a nd th e a dministra tive and legal expenses associated with a failure

aver aged an oth er 10% of asset s. The 30% loss of book value from asset sa les


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Under ideal bankruptcy procedures, liquidation occurs only when the liquidation value4

exceeds the value of the bank as a going concern. Haugen and Senbet (1978) therefore

argued that liquidation costs should be regarded as a consequence of economic distress and

not as a cost of financial distress.

Berger (1995) found empirical evidence supporting this hypothesis. He found a positive5

relationship between capital ratios and earnings for U.S. banks during the 1980s, a period

when the probability of bank failure and the expected costs of financial distress raised market

capital `requirements'. Banks that did not respond to these 'requirements' paid much higher

rates on their uninsured liabilities, which caused them to suffer lower earnings than other

exaggerates th e cost of financial distre ss because pa rt of the 30% undoubtedly r eflects

economic distress incurred earlier, since the reported book values of assets at failed

banks often oversta te economic value (see GAO 1990). There is als o disagreemen t over

how much of th e remain ing costs of liquidat ing th e individual a ssets sh ould coun t a s

financial ver sus economic distr ess costs. Int erest ingly, losses to creditors (includin g4

t he FDIC) from ban k insolvencies ar e often less than losses from insolvencies of

nonban king firms th at go th rough the ban kru ptcy process, presuma bly becau se the

resolution pr ocess for ban ks is more efficient (Kau fma n, 1994).

Par t of the costs of financia l distress a re borne by t he ba nk 's credit ors a nd par t

by shareholder s. To th e exten t th at creditors can foresee th e probability of incurr ing

th ese costs at t he time tha t th e debt is issued, th ey will raise their required int erest

rates a nd shift th e entire e x p e c t e d costs of financial distress t o sha reh olders u nder

risk neut ra lity. In response, sha reh olders ma y choose to redu ce these expected costs

by increasing the capita l ratio of th e bank t o th e point at which th e reduction in the

expected costs of financial distress just offsets the r edu ction in t he ta x benefits of debt .

In effect , mar ket capit al `requiremen ts' increase in r esponse to a rise in th e expected

costs of financial distress. 5


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banks.

Harris and Raviv (1991) surveyed more than one hundred papers on capital structure6

theories, many of which assume some sort of asymmetric information.

As y m m e t r i c I n f or m a t i o n a n d T r a n s a c t i o n s C os t s

Relaxat ion of th e M&M assu mpt ion of full informa tion leads t o a n um ber of

additional reasons that capital ratios may matter. The implications of asymmetric6

informa tion ha ve been stu died extensively in th e bank ing literat ur e becau se the

modern theory of financial intermediation stresses the informa tion acquis ition fun ction

of banks. This theory (e.g., Diamond 19 84) implies th at financial inter mediar ies exist

because they enjoy economies of scale and/or compara tive advantages in th e pr oduction

of inform at ion a bout borr owers. Comm ercial bank s specialize in lend ing to inform a-

tion-problematic borrowers, i.e., firms with idiosyncratic needs that are costly to

commun icate, part icularly small firms without established reputa tio ns. Ban ks a cquire

information in the loan screening and contracting process, and then augment this

information over time by monitoring the borrower's loan repayments and deposit

activity.

The private informa tion produced by banks regar ding th eir loan cust omer s also

creates an asymmetric information problem for banks vis-a-vis financial markets.

Bank managers will generally have more information about their own earnings

prospects an d finan cial condition t ha n t he capital ma rket s. Becau se of th is opacity

(Ross 1989), the market will draw inferen ces from th e actions of th e ban k. Manager s

may signal informa tion to the ma rket t hr ough capital decisions. If it is less costly for

a `good' bank to signal h igh qua lity thr ough increas ed leverage th an for a `bad' bank,


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However, the 1980s data on U.S. banks was not consistent with the empirical implications7

of either of these signaling hypotheses (Berger 1995).

Shareholders may also be reluctant to issue more equity because it may transfer wealth8

from old shareholders to old creditors if interest rates on outstanding debt cannot be easily

lowered to reflect the increased safety of the debt (Miller 1995).

a signaling equilibrium may exist in which banks that expect to have better future

perform an ce ha ve lower capita l (Ross 1977). Altern at ively, a signa ling equilibrium

may exist in wh ich h igher, ra th er th an lower capita l signals favora ble private infor-

ma tion (Acha rya 1988). 7

Asymmetric information combined with transactions costs of new issues may

also influence th e relative costs of intern al versus externa l finan ce an d t he r elative

costs of debt versus equity. When mana gers have significan t privat e inform at ion,

shareholder s ma y be relucta nt to issue n ew equity becau se it ma y sell at a discoun t. 8

In addition, transactions costs in ra is ing fun ds from exter na l sour ces, par ticular ly the

costs of issuing equity, may be quite subst an tia l. These costs include prepa ra tion of

the registration statement and prospectus, registration fees, printing and mailing

costs, un derwr iting fees, and possibly the cost of th e issue being `un derpr iced' (e.g.,

Ibbotson et a l 1988). In cont ra st, ban ks typically ha ve very low tra nsa ctions costs in

issuing new debt in the form of deposits. Ban ks may a lso hold a subst an tia l buffer of

additional capi ta l as fina ncial slack so th at th ey can borr ow addit iona l fun ds quickly

and cheaply in the event of unexpected profitable investment op portu nities. Similarly,

such a buffer of capital protects against costly unexpected shocks to capital if the

finan cial distr ess costs from low capit al ar e subst an tia l and t he t ra nsa ctions costs of

raising new capital quickly are very high.


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Myers (1984) and Myers and Majluf (1984) argued t hat firms establish a pecki ng

order in developing their financing strat egie s. At t he t op of th e pecking order is inter -

nally generated cash flows, which have no issue costs and no information problems.

If externa l fun ds ar e needed, debt is u sua lly preferred t o equity becau se its issuing

cost s a re u sua lly lower, an d because debt r educes verificat ion costs (e.g., Townsen d

1979). All of these incent ives may be accentua ted for sm all banks wh ich t ypically face

very high tr an sactions costs in issuing new equity.

Asymmet ric inform at ion p roblems m ay a lso lead t o agency conflicts bet ween

sh a reh olders a nd creditors t ha t a re exacerbated by conditions of finan cial distr ess.

Shar eholders may find that actions which ma ximize the value of all clai ms on th e bank

do not necessarily maximize the valu e of th eir own claims. This ma y lead t o at tempts

to shift wealth from creditors to sha reh olders. First , sha reh olders may have a moral

ha zar d opport un ity to exploit creditors by substitut ing riskier assets for sa fer ones

(possibly undertak ing negative net present valu e investm ent s) if creditors do not h ave

sufficient informa tion to react. Second, when a ban k is near defaul t, sh ar eholders ma y

lack incentives to cont ribut e new capita l even to fun d value-increasing investm ent s,

since most of the benefits would accrue to cred itors (Myers 1977). Thir d, sha reholder s

have incentives to continu e th e ban k's opera tions beyond t he point a t wh ich it sh ould

be liquidated in order to ma inta in at least an option value for th eir claims. Fina lly,

the bank may manipulate its accounts to mask the deterioration in condition by

understating loan losses or by `gains trading' in which assets with market values

above book va lues ar e sold and th ose with mar ket values below book a re kept (Car ey


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1993). These pr oblems of expropriat ion of creditor value a re compoun ded if th e debt

ha s long mat ur ity an d is difficult to redeem in the short term . This is becau se

sha reholders are more likely to expropriat e value if th ere is more time before cred itors

can react by ra ising ra tes or withdra wing credit (Flann ery 1994).

Similar t o the ar guments above for the other costs of financ ial dist ress, creditors

will demand compensation in the form of higher interest ra tes on debt for th e expected

value of these expropriations of their claims by sha reh olders under risk n eut ra lity. In

response, banks may optimally increase their capital ratios t o assu re creditors th at th e

bank is safe and shareholder and creditor interests are closely aligned, so that

sh a reh old ers ar e unlikely to engage in expropriation activities. In effect, agency

problems between shar eholders a nd creditors r aise mar ket capital `requirements'.

Other agency costs arise from a conflict of interest between shareholders and

managers when shareholders cann ot effectively monitor ma nagers' actions (J ensen an d

Meckling 1976, Grossman a nd Har t 1982, J ensen 1986). Higher debt put s pressure

on managers to generate cash flows and avoid their loss of human capital from

bankruptcy and therefore may give incentives to work harder, reduce expense

pr eference behavior, and ma ke better investmen t decisions. Sha reholders ma y also

compensate man agers in shar es and oblige them to hold the shares in order t o enh an ce

these incentives. Giv en t he ma na gers' holdings, fur th er increases in overa ll leverage

ma gnify th e man agers' stake in t he bank 's performan ce and may further h eighten

these incentives. In add ition, increasing debt r educes the scope for ma na gers to keep

the firm going after the point at which shareholders would gain from liquidation


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Regulators may also be concerned about the incentives shareholders provide managers.9

John et al (1995) argue below that a deposit insurance premium that reflects both leverage and

the structure of management compensation can lead banks to choose risk in accordance with

regulators' preferences.

(Har ris and Raviv 1990). Thus, sh ar eholder-ma na ger agency conflicts a re r educed by

increasing leverage. 9

Taken together, th e agency problems between shar eholders an d creditors a nd

between sha reholders and ma na gers confront sh ar eholders with a t ra deoff. Higher

capital avoids expropriation problems between shareholders and creditors but

aggravates conflicts of interest between shareholders and ma na gers, and vice versa for

lower capital. Unfortunat ely, the corporat e fina nce litera tu re ha s made litt le progress

in quan tifying this tra deoff, and so t he n et impa ct on mar ket capit al `requiremen ts' is

ambiguous.

The Sa fe ty Ne t

Th e depar tu res from t he M&M assumpt ions considered to th is point -- taxes,

financial distress costs, asymmetric information, and transactions costs -- may

influence the capital dec isions of an y firm. Ban ks, however, differ s ubst an tia lly from

most other fir ms becau se they are protected by a regulatory safety net. As will be

shown, t his pr otection from bank ru ptcy an d th e costs of financial distr ess will affect

ma rket capital `requirement s'.

We use the term `safety net' to refer to all government actions designed to

enhance the safety and soundness of the banking system other tha n the r egulation an d

en forcement of capita l requirements. The safety net includes deposit insura nce,


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The insulation may be incomplete if depositors are concerned that the insurer may not10

honor its commitments (e.g., Cook and Spellman 1994).

The safety net may also reduce market capital requirements if it forces banks to take on11

less portfolio risk than they otherwise would, since safer portfolios `require' less capital to

protect against financial distress costs.

unconditional payment gua r an tees, an d access to the discoun t window, as well as t he

ent ire pan oply of regulat ion an d super vision th at is not directly related t o capita l.

Although capital regulat ion a nd its enforcement a re also int ended to enha nce bank

safety, we wan t to consider h ow th e safety net affects m ar ket capita l `requirement s'

in the absence of capital regulation. The effects of regulatory cap ita l requ iremen ts an d

the motivations for both regulatory capital requirements and the safety net are

discussed below.

The safety net likely reduces market capital r equirem ent s' by insu lat ing ban ks

from potential ma rket discipline. For example, federal deposit insura nce insu lates

ba nks from price an d qua nt ity reactions by insur ed depositors t o ban k capital deci-

sions. This distortion could be elimina ted if deposit insur an ce premiums fully10

res ponde d to cha nges in risk. However, unt il recent ly, federal deposit insu ra nce

premium s were fixed and they now respond only slightly to changes in th e cap ita l rat io

(discussed below). The sa fety net ma y also blunt th e risk-pricing of u n i n s u r e d debt

if th e m ark et believes th is debt to be de facto insur ed or if the safety net a s a whole

acts as a su bsidy to the ban k, ra ising net cash flows. These condit ions would reduce

ma rket capital `requirement s' furt her. 11

In sum, our ana lysis suggests that several departur es from the frictio nless world

of M&M may help explain ma rket capital `requirements' for banks. Tax co nsider at ions


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13

This figure reproduces and extends a figure developed by Myron Kwast in U.S. Treasury12

(1991). We are grateful to Myron for providing the data and sharing his insights. Note that

these data are not fully consistent over time, and therefore should be used only to assess

general trends.

ten d t o redu ce market capita l requ iremen ts', the expected costs of financial distr ess

tend to raise these requirements', and tr ansa ctions costs a nd a symmet ric informat ion

problems m ay eith er increase or reduce th e capita l held in equilibrium. Fina lly, th e

federal safety net shields bank creditors from the full consequenc es of bank risk ta king

a nd th us tends to reduce mar ket capita l `requirement s'. This is consistent with the

fact tha t banks generally ha ve lower capital th an firms in a ny other industr y, includ-

ing financia l inst itu tions with similar portfolios th at ar e not subject t o th e safety net

(e.g., commercial finance compan ies). Additional support for t his h ypoth esis may be

inferred from examining how the int roduction of th e safety net h as influenced bank

capital ra tios over time.

I I I . The H is to r ica l Evo lu t ion o f Ban k Ca p i ta l Ra t ios in th e U.S .

The history of bank capital rat ios in th e U.S. reveals a rema rkable, centu ry-long

decline from the levels prior to the const ru ction of th e federa l safety net. Figur e 1

shows th e ra tio of equity to assets for the banking industry from 1840 to 1993. In12

1840, equity funded over 50% of banks' ass ets, a fter which t he ra tio fell fair ly stea dily

for a bout 100 years un til it settled in th e 6% to 8% ra nge from th e mid-1940s to th e

1990s.

Prior to the start of the National Banking era in 1863, capital ratios were

already declining significan tly. As the efficiency of the U. S. fina ncial syst em impr oved

from geograph ic diversificat ion, development of regiona l and na tiona l money mark et s,


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and introduction of clearinghouses and other mutual guarantee associations, the

probability of ban k failur es declined. In the fra mework described above, th is would

reduce market capital `requirements', because less capital was needed to protect

against th e risk of finan cial distress. The dat a a re consistent with th is hypoth esis.

The four vertical lines in Figure 1 identify significant chan ges in r egulat ion th at

may have altered the historical path of bank capital ra tios. The Na tional Ban king Act

of 1863 contained regulations that bolstered confidence in the safety of the new

nat ional banks. Th ese bank s were requ ired to deposit $10 in U.S. governm ent bonds

with t he Comptr oller of th e Curr ency for each $9 of na tional ban k notes issued, th us

amply collatera lizing the ne w cur ren cy. This should have grea tly reduced the capit al

`required' by the holders of th is bank debt, since th e safety of th e notes did not depen d

upon the solvency of t he ban k. In pr inciple, a `nar row' na tional ban k could have ha d

a 10% capital/asset rat io by simp ly ra ising $9 in deposits for each dollar of equity a nd

bu ying only govern men t bonds. While th is is a limiting case, th e implicit 10%

regulatory capital ratio for such a bank was less than one-quarter of the average

capital ratio of the time. The data show an accelerat ed ra te of decline of capita l ra tios

following 1863, consistent with the hypothesis that the Ac t redu ced m ar ket capit al `re-

quirements'.

The creation of the F ederal Reserve in 1914 also reduced the risk of ban k failur e

by permitting banks to obtain liquidity through discounting assets at the Federal

Reserve rat her th an incurr ing losses from th e distress sa le of asset s to meet liquidity

needs. The int roduction of th e Federa l Reserve also enh an ced liquidity by providing


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We mark the implementation date as 1990, although some banks may have reacted to13

announcements of RBC earlier.

a more r e liable system for clearing checks at par . Despite th ese reductions in th e

expected costs of finan cial distr ess, th e data suggest th at th e creat ion of th e Federal

Reserve led to, at m ost, a sma ll redu ction in capital r at ios.

The creation of the FDIC in 1933 provided unconditional government

guaran tees for most bank creditors. The fixed -ra te (non-risk-based) deposit in sur an ce

lowered marke t capita l `requirement s' by guara nt eeing depositors repa yment even if

th eir bank failed. Among oth er regulat ory cha nges of th e time, restr ictions were

placed on the interest rates b an ks could pay on deposits. This provided an a dditional

subsidy to banking that also made uninsured bank debt safer, reducing mar ket capita l

requirements further. The data su ggest that th ese chan ges had a larger and more

long-lasting effect than th e creat ion of the Federal Reserve. By the earl y 1940s, capita l

ha d dropped into th e 6% to 8% ra nge where it remains today. Thus, after a centu ry

of substantial decline, capital ratios remained relatively stable for the next half-

century.

The fina l event sh own in Figur e 1 is the initiat ion of th e Basle Accord on r isk-

based capital (RBC) requirements along with some other, near ly coincident, regula tory

changes. RBC requ iremen ts were pa rt ially implemen ted in 1990 and t ook full effect

in 1992. U.S. regulators also impo sed a leverage requirement in 1990 based on t ota l13

asset s. In 1991, th e prompt corrective action feat ur e of th e FDIC Impr ovement Act

(FDICIA) created additional motivation for ban ks t o raise t heir capita l ra tios to avoid


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See Jones and King (1995), Garcia (1995), and Kaufman (1995) below for discussions of14

FDICIA, Szeg (1995) for discussion of RBC implementation in Europe, and Cummins et al.

(1995) for analysis of RBC and prompt corrective action in the insurance industry.

supervisory san ctions. The introduction of risk-based deposit insura nce premium s14

in FDICIA added yet another incentive for ba nks t o increase th eir capita l ra tios above

th e new, higher , regula tory minimu ms. The combined effect of th ese regula tory

actions a ppears t o ha ve been successful in raising capita l ratios. The aggregat e

equity/asset ra tio rose from 6.21% at th e end of 1989 to 8.01% at th e end of 1993, an

increase of almost 30% i n four year s. Although m ar ket `requir emen ts' ma y also ha ve

risen in th e early 1990s becau se of concerns a bout finan cial distr ess in the ba nking

system, it seems plausible that the regulatory changes accounted for much of the

increase in capital r at ios.

I V. Wh y D o R e gu l a t or s R e q u ir e F i n a n c ia l In s t it u t i on s T o H o ld C a p it a l?

In this section, we examine why cap ita l rat ios ma tt er to bank regula tors. As in

th e m ar k et capital `requirement s' section a bove, we take a s given the sa fety net of

government guar an tees and regulations that pr otect the safety and soun dness of

banks.

Regulators require capital for almost all th e same reasons t ha t other un insu red

creditors of banks `require' capita l -- to protect themselves against t he cost s of fina ncial

distress, agency problems, and t he reduction i n m ar ket discipline cau sed by th e sa fety

net. The FDIC is effectively th e largest u ninsur ed creditor of most ban ks in th e U.S.

becau se in t he event of ban k failur e, it pa ys off th e insur ed depositors a nd st an ds in

their place for a shar e of the failed bank's asse ts a long with oth er u ninsur ed creditors.


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The FDIC a ls o bears man y of th e administra tive costs when a bank fails. Other

aspects of the safety net -- such as Federal Reserve discount window lending and

unconditional guaran tees on FedWire payments -- create a dditional u ninsur ed risk for

the government . Regulators, as representat ives of the F DIC, th e Feder al Reserve, and

the ta xpayers who stand behind th em, are vulnerable to the same costs of f ina ncial dis-

tress and expropriations of value as other creditors.

Regulators also respond to other externalities associated with financial

interm ediaries on behalf o f th e rest of society. The pr incipal concern is systemic risk .

The failure of a large num ber of banks or t he failur e of a sm all nu mber of lar ge banks

could set off a chain reaction th at may undermine the sta bility of th e fina ncial system.

Public informa tion ab out t he condit ion of individua l banks is h ighly imper fect an d so

when a n um ber of ban ks fail, it ma y be difficult t o tell whet her t he cause is idiosyn-

cra tic shocks t o individua l bank s or a more widespread sh ock t ha t jeopar dizes ma ny

other bank s. Thus, the news tha t some banks failed may creat e destr uctive `pan ic'

runs on other solvent, but illiquid banks by uninsured creditors who are unsure

whether the shock may affect their banks (Bhatt acharya and Thakor 1993). Int erba nk

markets may be another channel through which the problems of one bank are

transmitted rapidly to other banks since interbank transactions are large, variable,

an d difficult for outs iders to monitor (Gut ten ta g and H err ing 1987).

These systemic problem s can in flict h eavy social costs. Ban ks bu ild up pr ivate

informa tion on informa tionally opaque loan customer s t hr ough screening, cont ra cting,

a nd monitoring over the cour se of bank -borrower relationsh ips. When a nu mber of


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18

solvent but illiquid banks fail, the value of this information and the relationships

th emselves m ay be lost, ma king it difficult for some borr owers t o cont inue financing

invest men ts. In tu rn , th is reduction in credit extended ma y exacerbate regiona l or

ma croecon omic difficult ies (Bern an ke 1983). Significan t ban k failur es may also

threaten the integrity of the payments system, making it difficult for financial

resou rces to flow to where th eir retur ns ar e highest. Moreover, widespread ban k

failur es could under mine t he effectiveness of monet ar y policy. According to the

`lending view', monetar y policy operates largely thr ough changing the qu an tit y of bank

loan s, which would be difficult t o cont rol in a bank ing panic (Bern an ke an d Blinder

1992). Concer n a bout th ese social costs from a syst emic crisis ma y lead regula tors t o

att empt to achieve a h igher degree of safety for ba nks by requiring higher capital

rat ios than if they were acting solely to protect th e gove rn men t's position as un insu red

creditor. Note tha t concern about systemic risk is n ot only a motivation for r egulat ory

capita l requirement s, but is also a ma jor motivat ion behind th e safety net itself.

Not a ll observers a gree tha t systemic risk is an importa nt issue (e.g. Benston

an d Kau fma n, 1995). In th e absence of systemic risk or oth er significan t nega tive

exter na lit ies from ban k failur es, the governmen t should behave, in pr inciple, like a

private-sector unin sur ed creditor. The governm ent sh ould price risk th rough deposit

insurance premiums an d set capital sta nda rds a nd closure r ules similar to covenant s

contained in standard debt contracts (e.g., Black et al 1978, Acharya and Dreyfus

1989).

Despite the fact tha t the government is th e largest u ninsur ed creditor of ban ks,


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19

it does not exercise market dis cipline a nd `requ ire' cap ital in t he sa me way t ha t other

un insu re d creditors do. First , it relies very little on explicit risk pricing. FDIC

insura nce premiums were not tied to risk un til recently, and t he curren t different ial

for risk is very small. As of 1994, ba nks with th e best exa mina tion ra tings (composite

CAMEL ratings of 1 or 2) that were also well capit a lized (a t lea st 10% tota l risk-based

capita l ratio, 6% Tier 1 rat io, and 5% Tier 1 leverage rat io ) paid 23 ba sis point s of total

deposits (23 cents per $100 of deposits). In cont ra st, banks with the worst exa min at ion

rat ings (CAMEL 4 or 5) that were under cap italized (less than 8% tota l ra tio, 4% Tier

1 r a ti o, or 4% Tier 1 leverage rat io) pa id 31 basis point s. This maximu m price

difference of 8 basis po ints for risk is far below t he differen tia l th at would be cha rged

in the debt markets for such la rge differen ces in r isk (e.g., th e differen tia l between B-

ra ted an d AAA-ra ted bonds is typically well over 100 ba sis point s).

The 8-basis-point differe nt ial is also far less th an th e differen ces in actu ar ially

fair insura nce premiums estimated from opt ion pr icing models. For exam ple, Kuest er

and O'Brien (1990) estimat ed tha t fair premiums for most firms would be v ery low, less

than 1 basis point, while a few very risky out liers had fair premia in th e 1000's of basis

points. While this approach requires a n um ber of simplifying assum ptions, the r esult

that m ost banks ar e very safe an d a few banks ar e extremely risky is consistent with

the rest of this liter at ur e (e.g., Ronn an d Verm a 1986), an d suggests t ha t t he 8-basis-

point maximum FDIC differential does not capture the existing risk differences.

Moreover, it is not clear th at th is small price differen tia l would by itself be a critical

factor in deterring banks from holding low capita l rat ios. Since th e FDIC does so lit-15


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20

The 8 basis point differential is an upper bound to the additional cost to the bank, because15

banks can reduce also premiums by shifting from deposit to non-deposit funding, by shifting

assets into lower risk-weighted categories, or by shrinking the size of the bank. At the upper

bound, the 8 basis points

would reduce return on assets (ROA) by about 5 or 6 basis points pre-tax (assuming deposits

fund about 60-80% of deposits), or by about 3 or 4 basis points after-tax.

Note that when banks have private information about their portfolio risks, it may be16

undesirable or even impossible for regulators to price the expected costs of risk on an

actuarially fair basis. In order to reduce moral hazard incentives, it may be desirable to

provide a subsidy to banks that increases their franchise values and improves their incentives

to keep their risks under control (Buser et al 1981, Chan et al 1992).

tle pricing of risk, it must re ly more on capita l requirem ent s th an th e privat e sector. 16

Also, regulat ors usually do not rat ion th eir credit -- i.e ., deposit insu ra nce cover-

age -- to limit their risks as market participan ts do. Market s routinely refuse to exten d

a dditiona l credit to a ba nk or other firm if the going interest r at e does not cover th e

risk and raising the interest rate would create moral hazard or adverse selection

problems. In con tr ast , regulat ors gener ally do not explicitly ra tion deposit insu ra nce

cover age. In most cases, the FDIC's insu ra nce liability is simply determined by th e

demand and supply for the individua l ban k's insu red deposits. Similarly to th e weak

pricing r esponse, th e fact th at regulators usua lly do not ra tion credit increases t heir

reliance on capital regulation.

Regulat ors do have some indirect m eans of pressur ing banks t o raise capita l

rat ios, such as cease-and-desist orders, t ota l with dra wal of insu ra nce covera ge, ban k

closure, limits on asset growth and brokered deposits, prohibition of dividend

payments, etc. (Buser et al 1981). However, these tools are blunt, unc ert ain , an d a pply

to only a small percent age of institu tions. One of the purposes of t he p rompt corr ection

action feat ur e of FDICIA was t o improve capit al-based incent ives by mak ing some of


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21

Kwan and Eisenbeis (1995) below provide evidence that cost-inefficient banks take17

greater risks to exploit the safety net than other banks because they have lower market values

these regulatory actions manda tory wh en t he capita l rat ios fell int o designat ed zones.

None th eless, J ones a nd King's (1995) evidence below suggests tha t t he m an dat ory

actions are not likely to apply very often to the banks that ar e u ndert aking substa nt ial

risks.

In addition, there is the possibility that these blunt actions could create

additional moral hazar d incentives to take a dvant age of th e safety net . For example,

the deposit insur er could suffer increased expected losses from ra ising th e capita l ra tio

at which banks ar e closed because some banks may take hi gher r isks and s uffer la rger

losses before th e insurer can detect t hem (Herring an d Van kudr e 1987, Davies an d

McManu s 1991). This is becau se the capita l ratio at which moral hazard incentives

become importa nt depen ds more on h ow far th e capita l ra tio is from t he closur e point

tha n on th e absolut e level of th e capit al ra tio. Similar increas es in risk-ta king could

be forthcoming in r esponse to oth er costly inter ventions by regula tors.

Thus, regulatory capital r equirements differ subst an tially from mar ket-based

capit al `requirement s'. They ar e generally blunt stan dar ds th at respond only

min ima lly to perceived differences in r isk rat her th an th e cont inuous prices an d

quantity limits set by uninsured creditors in response to changing perceptions of the

risk of individual banks. The limited ability to price or rat ion th e benefits of th e safety

net in response to cha nges in bank risk may be quite costly if it permits risky ban ks

to take advan ta ge of th e safety net by choosing lower capita l ra tios tha n th e market

would require t hem to hold in t he a bsence of th e safety net. 17,18


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22

and higher costs of capital.

Ironically, regulators may have an informational advantage in pricing risk and/or setting18

capital requirements because of access to confidential bank examination information (Berger

and Davies, 1994).

V. H ow Sh ou ld R egu la t or y Ca p it a l St a n da r d s Be Se t?

Capital regulation is motivated in part by concern over the negative

extern alities tha t m ay result from bank default t hat are n ot t aken into account in

ma rk et capita l `requirement s'. One obvious regulat ory remedy would be to require

banks to hold so much equity that t he probability of defau lt is negligible. Indeed, if th e

M&M proposition applied to banks this would be a costless solution. B ut if, as we h ave

ar gued, increasing equity beyond t he ma rket `requirement ' reduces th e value of th e

bank and increase s its weight ed avera ge cost of financing, th en h igher regu lat ory re-

quir em ents m ay impose social costs. In competitive mar kets in the long run ,

regulat ory capit al costs a re likely to be passed on to bank customers, so th at th e size

of th e ban king indu stry and th e qua nt ity of interm ediation ma y be reduced. Thus,

capital regulation involves a t ra deoff between th e ma rgina l social benefit of redu cing

the risk of the negative externalities from bank failures and the marginal social cost

of diminishing intermediation (Santomero and Watson 1977).

These social costs and benefits from regulatory capital requirements differ

across banks and over time. `Ideal' regulatory capital requirements wo uld r eflect th ese

differences to equat e the margina l social cost of higher capita l with th e ma rginal social

ben efit for each ban k for each time period. For exam ple, a bank t ha t poses no

significan t externa lities would be assigned a r elatively low capita l requirement t ha t


25/69

23

reflects only the government's claim as an uninsured creditor. In cont ra st, a ba nk th at

is likely to tra nsmit shocks to other ban ks because of key ro les in t he payment s system

and interbank markets would be subject to a high capita l requ iremen t. Similarly, th e

requirements would be continuously updat ed with chan ges in the r isk p ositions of each

bank an d th e externa l costs of th ese risks.

Unfortu nat ely, implementat ion of such a n `ideal' system would be pr ohibitively

expen sive , if not impossible. Regulators lack precise estima tes of social costs a nd

benefits to tailor a capital requirement for each bank, and cannot easily revise the

requirements continuously as conditi ons change. Becau se regulat ion and su pervision

a re costly, ban ks are monitored at only at discrete int ervals. Under FDICIA, most

ban ks r eceive full scope, on-site exam ina tions only once an nu ally.

In practice, capital regulation stipu lat es un iform , minimu m r at ios below which

banks are subject to regulatory sanctions, and these minimums remain relatively

st able over a period of years . Between on-site examina tions, complian ce with t hese

min imu ms can be easily monitored by inspection of the qu ar terly Call Report.

Regula tors also have discretion t o set somewhat higher requiremen ts for individua l

bank s th at ar e perceived to pose higher risks.

In the rem ainder of this section, we examine h ow regulatory minimum capita l

st an da rd s might be set, given these constr aint s. We explore which finan cial

instr um en ts should count as regulatory capital and how the numerat or an d

denominator of the regulatory capital ratio should be measur ed. We also discuss some

policy alt ern at ives to improve the effectiveness of capit al r egulat ion.


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24

Relative to debt instruments that may be considered as regulatory capital, equity has the19

additional benefit that it absorbs losses before the point of bankruptcy and permits the bank to

continue as a going concern. This property is important to the extent that shareholders would

have difficulty raising new equity to avert bankruptcy even when the bank has positive value

as a going concern.

Wh a t S h o u l d C o u n t a s R e g u l a t o r y C a p i t a l ?

The main regulatory policy goals of protecting the government's uninsured

claims on banks and guarding against the external costs of bank failure such as

systemic risk suggest that instruments th at qualify as regulatory capita l should ha ve

three ma in cha ra cteristics. First, claims th at qualify as regulat ory capita l should be

jun ior to t hose of the deposit insurer , so th at th ey serve as a bu ffer t o absorb losses

before th e government . Second, a financial inst ru ment th at coun ts a s capita l should

be `pat ient money'. It should not be redeemable without assur ed refun ding by th e

same or other creditors or sha reholders dur ing the t ime period needed to evaluate a

significant shock so that it can provide a stable sour ce of fun ds dur ing a possible pa nic

ru n on th e ba n k by oth er creditors. This reduces th e potent ial for, and scope of

contagious bank run s and allow s regulat ors m ore t ime to evaluate an d respond to th e

sh ock . Fina lly, an instr umen t th at coun ts as regulatory capita l should reduce th e

ba nk 's mora l hazar d incentives to exploit th e protection of th e safety net by under-

taking excessive portfolio or leverage risk.

We consider next the extent to which equity meets these three criteria for

regulatory capita l. Equity is junior to all other cla ims an d thus ser ves well as a buffer

aga inst loss for the deposit insurer. It also has an indefinitely long maturity and19

cannot be redeemed during a crisis period. Regulat ors typically prohibit excessive divi-


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25

dend payou ts or stock repu rchases for distressed ban ks, so th at equity serves well as

a stable source of funds while regulators and market participants sort through the

effects of shocks. However, equity ma y not always achieve the t hird objective of

disciplining r isk ta king. Regulat ory requ iremen ts to increase equity-to-asset ra tios

reduce leverage risk, but the effect on portfolio risk and on the overall risk of

bank ru ptcy is a mbiguous in some circum stan ces.

Koehn and Santomero (1980), Keeton (1988), and Kim and Santomero (1988)

used ut ility maximizat ion models to show tha t an increase in th e required equity-to-

asset ra tio might either increase or decrease t he portfolio risk chosen by a bank. If

equity is r elatively expensive (for rea sons discussed a bove), risk-averse ban k owners

may choose to take pa rt of th eir loss from a h igher equit y requirem ent in th e form of

an increase in risk by choosing a hi gher point on th e risk-expected retu rn front ier. In

effect, they may respond to a forced reduction in leverage risk that lowers expected

ret ur n by choosing a portfolio with h igher risk an d higher expected retu rn . In

contr ast, Fur long and Keeley (1989) an d Keeley an d F ur long (1990) found th at value-

maximizing banks with publicly traded stock will always reduce portfolio risk in

response to a higher equity requireme nt becau se it increases t he sh ar e of losses born e

by the ban k owner s relative to th e FDIC. However, Gennott e and Pyle (1991) found

tha t value-maximizing banks may increase portfol io risk and th e pr obability of failur e

if bank investment s are subject to decreasing retur ns to investment, as may be the case

for t he type of informa tion-intensive, non-ma rketa ble loan s in which ba nk s s pecialize.

Even with a n increase in the probability of failure , however, Gennott e and Pyle foun d


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26

th at th e expected cost t o the deposit insur er genera lly decreased in response t o an

increase in required equity because the size of the insurer loss decreased

proportionat ely more tha n th e increase in the probability of failure. Fina lly, Avery and

Berger (1991b) showed that expected losses fo r th e insu rer could rise from a n increase

in r equired equity in t he Gennotte a nd P yle model, but some extreme distributiona l

assumptions about investment retur ns were needed. Thus, the theoretical issue of how

higher r equired equity ra tios a ffect ban k r isk-ta king is un resolved.

In contrast, the empirical evidence generally suggests that higher equity is

associated with lower overall bank risk. Vi rt ua lly every ban k failure m odel finds t ha t

a h igher equit y-to-asset ra tio is associated with a lower futu re pr obability of failur e

(e.g., Lane et al 1986, Avery and Berger 1991b, Cole and Gu nt her 1995). Nonet heless,

th e relat ionsh ip between th e equity-to-asset ra tio and bank safety is often relatively

weak. A higher equity ra tio does not always pr edict a lower probability of failur e over

all reasonably near futur e periods (Thomson 1991), and often expla ins very litt le of th e

variat ion in bank performa nce.

This is an importa nt a rea for fut ur e research. We lack clear evidence about

whether t he positive (albeit weak) relationship between equity and bank safety r eflects

a decrease in portfolio risk in add ition t o the decline in leverage risk. Also th e extent

to which the empirical results reflect the effects of regulatory versus market capital

`requirements' is not always clear.

We next consider subordinated debt, which is often included in regulatory

capita l. Subordina ted debt is jun ior to all claims oth er tha n equity an d so serves as


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27

In the interest of brevity, this discussion ignores hybrid instruments such as perpetual,20

noncumulative floating rate notes that have some of the characteristics of equity. We also

neglect several other items that count as regulatory capital under the Basle Accord.

To qualify as Tier 2 capital under the Basle Accord, subordinated debt must have original21

weighted average maturity of at least 5 years, and the amount that counts as capital is reduced

over the last 5 years of term.

a buffer against losses by the deposit insurer. Subordinated debt is also generally20

`pat ien t money' th at h elps provide sta ble fun ds to weat her sh ocks to confidence. It

typically has a long mat urity and is difficult to red eem quickly dur ing a crisis per iod. 21

Although subordinated debt increases leverage risk , it ma y det er port folio risk t aking.

Subordinated creditors have strong incentives to monitor bank risk t ak ing an d impose

discipline -- provided they believe that they will not be protected by the safety net.

Indeed, their loss exposure, and hence their perspective is simil ar to th at of the deposit

insurer. They are exposed to downside risk t ha t exceeds the sha reh olders' equity, but

their potential upside gains are contr actually limited. In cont ra st t o sha reh olders who

may choose higher points on t he r isk-expected r etu rn front ier, subordina ted creditors

generally prefer safer portfolios an d ar e likely to pena lize ban ks t ha t t ak e significan t

risks.

The price discipline of actively tra ded su bordinat ed debt -- which is register ed

moment-by-moment in seco nda ry mar ket prices that can m ove by small fractions -- is

arguably a much quicker and perha ps more precise way of contr olling ban k r isk t ak ing

tha n regulatory measures which ar e often blu nt a nd cumber some to deploy. A falling

price of subordinated debt can a lert oth er creditors a bout th e condit ion of th e ban k or


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28

In addition, market prices tend to be more forward looking than regulatory examinations,22

and may provide regulators with valuable information on the market's perceptions of the risks

taken by banks (Horvitz 1983).

actions of the managers, creating a broader mark et reaction. Ironically, when bank22

risk increases un expectedly, ban ks ma y not have to pay higher r at es or face possible

quant ity discipline for a period of time unt il the subordinated debt , which typically has

a long mat ur ity, must be redeemed. For this reason, it ma y be useful to have some

regular t urn over of subordinated debt, even th ough it weakens the role of subordina ted

debt as `patient money'. For example, if banks were required to stagger t he ma tu rities

of their long-term debt so that only a modes t proportion tu rn ed over each per iod, pr ice

and quantity sanctions may be effective and informative, but sufficiently limited in

magnitude to provide time for crisis resolution or orderly closure (Wall 1989, Evanoff

1991).

Despite t he th eoretical virt ues of subordinat ed debt, the literatu re on mar ket

discipline usu ally found th at t he price of subordina ted debt was not very responsive

to measures of bank risk t ak ing in t he ea rly 1980s (e.g., Avery et a l 1988, Gort on an d

Sa nt omero 1990). The price reaction t o balance sheet measur es of risk was quite

limited, although the response was somewhat great er to cha nges in bond r at ings. The

weak responses to measured risk may reflect a lack of ma rket d iscipline, bu t th ey may

also reflect difficulties in measu ring ba nk risk. Moreover, the limited responsiveness

may also reflect a presumption by investors that the large banks that issued

subordinated debt in the early 1980s were considered to be too big to fail' . More recent

results suggest tha t subordinated debt prices may have become more sensit ive to ban k


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29

risk, perhaps reflecting increases over time in the willingness of regulators to let

holders of th is type of debt a bsorb losses (Flann ery an d Soresca, 1994). FDICIA's

emphasis on early closure and least cost resolution ma y un derm ine t he `too big to fail'

presumption even furt her, but additional resea rch will be needed t o resolve this issue.

Fina lly, we consider t he potent ial of uninsur ed deposits as r egulatory capita l.

Uninsured depositors in domestic bank offices have claims of equal status to the

deposit insurer, rather than providing a buffer that absorbs losses before the

governmen t. However, un insured deposits in fo reign offices of U.S. ban ks do have the

a dva nt age of being jun ior claims to the F DIC. The Budget Act of 1993 provides for

U.S. depositor preference in the event of ban k failure, so that un insu red depositors in

U.S. banking offices and the FDIC (which st ands in the place of insur ed depositors) ar e

senior claima nt s over depositors in foreign offices an d all oth er creditors. Em pirical

studies usua lly found th at ban k risk affects uninsur ed deposit ra tes, but th e effect wa s

typically weaker for banks that may be `too big to fail,' similar to the results for

subordinated debt (H an na n a nd H an weck 1988, Ellis an d Flan nery 1992). However,

uninsur ed deposits are not `patient money' tha t pr ovides a st able source of fun ding in

a crisis. Depositors can u sua lly `ru n' an d deposits can be redeemed for cash quickly

when concerns a rise abou t th e solvency of an inst itut ion, possibly leading t o systemic

risk problems. For example, the devasta ting run on Continent al Illinois ban k in 1984

wa s initia ted by un insu red foreign depositors. Becau se of th is problem, un insu red

deposits ar e not coun ted a s regulat ory capital.

In sum, equity and subordinated debt broadly sat isfy the criter ia for r egulat ory


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capital, but uninsur ed deposits do not. Both equity and subordina ted debt a re junior

to the deposit insurer an d provide buffers against government losses. Both instru -

men ts ar e also `pat ient money' th at is usua lly difficult t o redeem du ring a fina ncial

crisis, mitigating systemic risk pr oblems an d buying time for r egulat ors to deal with

th e crisis. Both equity an d subordinat ed debt likely reduce bank risk ta king some-

what , but th e th eoretical a nd em pirical evidence is mu ch weak er on th is point.

Me a s u r e m e n t o f R e g u l a t o r y C a p i t a l

In order to be useful, regulatory capital must be measured with reasonable

accur acy. However, th is is seldom a simple ta sk. For example, equity capita l is th e

residual claim on the bank -- the value of obligations of others to pay the ban k plus th e

valu e of any other ta ngible an d inta ngible a ssets less th e value of obligations of the

bank to pay others. Therefore, meas ur emen t of equity depends on how a ll of a ba nk 's

finan cial instru ment s and other assets ar e valued.

If all claims were traded in complete, well-organized secondary markets, the

measurement of equity capital for regulatory p ur poses would be relat ively str aight for-

wa rd . It could be calcula ted as t he `regulat ory value of equity' -- th e differen ce

between th e ma rket value of the ban k's assets (on a nd off the balan ce sheet) and t he

ma rket va lue of th e ban k's liabilities (on an d off th e bala nce sheet ), net of th e value

of limited liability (which includes t he va lue of access to deposit in sur an ce). Tha t is,

the market values of all liabilities would be adjusted as if the shareholders had to

rep ay all t he bank 's obligations, even in the event of failure. This measure is the

amoun t of value tha t could be lost before any of th e bank's obligat ions to pay would go


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This definition may somewhat understate the economic value of capital because part of23

the limited liability is voluntarily absorbed by uninsured creditors and paid for by

shareholders through higher interest rates.

un sa tisfied. The possible alternative of using the bank's market value of equity is23

unsu itable for regulatory pur poses because it cont ains th e value of th e ban k's limited

liability, its option to put the bank's assets to its creditors . Since the FDIC bear s much

of the cost wh en t his option is exercised, regula tors sh ould not coun t t he va lue of th e

option a s par t of regula tory capit al.

This `regulat ory value of equity' -- assuming th at sufficient m ar ket price in-

form a t ion is a vailable to compu te it -- is also superior to the book value of equity

typically used by regulators. The book value of equity measu res most on-bala nce sheet

assets and liabilities on an historical cost basis tha t ma y not reflect cur ren t values, a nd

treat s most off-balance sheet items as having zero value. The book v alue mea sur e does

not r eflect th e bank's ability to with sta nd a loss without imposing costs on creditors,

nor does it reflect the constr ain t on mora l ha zard . Moreover, as noted above, book

values are subject to `gains tr ading' by banks to increase their r eported capit al with out

creat ing value.

Unfortunately, not all of the bank's assets and liabilities are traded on well-

organized seconda ry ma rkets. The most difficult obsta cle to compu ting t he economic

valu e of equity is th e substa nt ial volume of imperfectly mar keta ble assets held by

ba nk s . As discussed above, ban ks specialize in ma king loan s to and providing

guar an tees for informa tion-problema tic borrowers. Although banks ha ve ma de

substant ial advances in securitizat ion, it is often difficult to overcome t he asymm etr ic


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informa tion problem. When this problem is acute, th e mar ket breaks down becau se

no buyer is willing to pay a price equa l to the value of th e asset to the ban k based on

its private information.

Several stu dies (e.g., Benst on et a l 1986) ha ve recommended th at ban ks adopt

mar ket value account ing (MVA), in which th e report ed values on financial sta tem ent s

-- an d th erefore mea sur ed capit al -- would reflect mar ket va lues. Virtu ally all of th e

MVA proposals advocate mar king-to-ma rket finan cial instr umen ts th at ar e t ra ded in

well-organized seconda ry mar ket s with easily observable prices. Man y also propose

that estimates of market values be reported for nontraded assets, such as loans to

sma ll borrowers th at do not ha ve access to finan cial markets. This creat es the

conceptua l problem of how to define th e mark et value of an essent ially un ma rk eta ble

asset, such as a loan to small borrower unk nown t o th e public. Although th ere ar e a

nu mber of possible implicit values that could be assigned to such a loan, the private

nature of the information used would create a difficult verification problem for

regulators a nd au ditors (Berger et al 1991).

Accou nt an ts an d ban k r egulators have also initiat ed moves towar d MVA an d

disclosures of market values as supplement ar y informa tion on finan cial statem ents.

The Fina ncial Accoun ting Standa rds Boar d has issued several proposals. FAS 107

required disclosures of `fair values' for all financial instruments as supplementary

informa tion sta rt ing in 1992 for lar ge firms a nd in 1995 for small firms. Disclosur es

do not affect reported income or capital, but par t of th e pu rpose was to ma ke a vailable

infor ma tion tha t ma y be used to facilitat e a fut ur e movement t owar d MVA. FDICIA


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similar ly requires disclosures of estimated mar ket values in Call Reports an d other

documen t s filed with regula tory agencies. FAS 115 implemen ted a form of `par tial

mar ket value account ing' in 1994, in wh ich securit ies tha t a re `available for sale' ar e

ma rked t o mar ket on th e balance sheet, affecting measured equity capital. There is

no account ing chan ge for other a ssets or for liabilities, and in come sta tement s ar e not

affecte d, so that t he cha nge in reta ined ear nings is not reported as income. Bank

regulators have chosen not to implement this cha nge in calculat ing regula tory capita l.

Despite all this academic and regulatory attention, however, there has been

rela tively litt le empirical evidence on the effects of MVA. Thr ee of th e paper s below

advan ce th is line of research . Car ey (1995) exam ines t he likely effects of a ver sion of

secur ities-only par tia l MVA (SOPMVA) similar to FAS 115 in wh ich only tr adea ble

securities are mar ked-to-mar ket, while other assets a nd liabilities remain at hist orical

cost. He finds tha t this cha nge could slight ly impr ove th e system by mea sur ing one

group of assets more accura tely and by reducing wasteful `gains tr ading' be ha vior. But

SOPMVA may also make measured capita l less accurate if tr adeable secur ities function

as a hedge against interest rate risk created by a du ra tion m ismatch elsewhere in t he

port folio. If th e hedge position is mar ked to ma rket, but th e under lying exposur e is

not, SOPM VA may also creat e ar tificial volatility in t he m easur ed capital of a bank

th at h as a ma tched book on a ful l MVA basis. Car ey's analysis suggests, however,

th at SOPMVA would have little effect on ban k failure r at es.

Barth et al (1995) examine the validity of common criticisms of MVA by

analyzing the empirical effects of SOPMVA on ban k income, capit a l, and st ock mar ket


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va lue s. Th is is also similar to FAS 115, alt hough as n oted, FAS 115 does not affect

reported income. They find th at SOPMVA does ra ise th e volat ility of reported ear n-

ings, but t ha t ban k sha re prices do not reflect th is extra volatility. SOPMVA would

also increase the number of violations of regulatory capital standards, which may

distort behavior if ban ks u se secur ities to hedge int erest r at e risk elsewhere in t he

port folio that is not mar ked-to-mar ket. Bart h et al's finding th at t he stock ma rket

generally does not r eact t o the volatility in t he earn ings on sec ur ities is consisten t with

th e possibility that th ese secur ities often do hedge risk elsewhere in t he port folio.

J ones and King (1995) test an alternat ive approach t o MVA for adju sting capit al

to reflect chan ges in t he credit qua lity of th e loan port folio. Inst ead of ad justing th e

values of individual loans to reflect changes in the creditworthiness of borrowers --

which poses numerous problems for loa ns to inform at iona lly opaqu e borr owers -- they

adjust the loan loss reserve account to reflect changes in the credit condition of the

ba n k 's ent ire loan port folio. This has th e same effect on report ed equity capital as

reductions in individual loan values. Berger et al (1991) ear lier showed that adjust ing

loan loss reserves to reflect nonperforming loans (past due, nonaccrual, or

renegotiat ed) improved the pr ediction of futu re loan cha rge-offs an d could potentia lly

make risk-based capita l significan tly more accur ate. J ones an d King (1995) show th at

adju s ting loan loss reser ves to reflect classified asset s -- asset s categorized by b a n k

e x a m i n e r s as su bsta nda rd, doubtful, or loss -- does an even bet ter job of captu ring

declines in credit quality. Moreover, a simulation of th e prompt corr ective action r ules

of FDICIA using data from the 1980s suggested that t his adjust ment t o capita l may


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significantly improve the tradeoff between Type 1 errors (troubled banks not being

cat egorized as un dercapita lized) an d Type 2 err ors (hea lthy bank s being cat egorized

as un dercapitalized).

Thus, the implementa tion of SOPMVA is un likely to improve the mea sur emen t

of capit al significan tly. However, a form of pa rt ial MVA in which a ll financial

instru ment s -- including off-balance sheet instru ment s a nd informa tiona lly opaque

loans -- a re a djusted for chan ges in m ar ket interest ra tes a nd foreign excha nge ra tes

cou ld result in significan tly bett er measu rement of capita l. Movement t owar d full

MVA or a n appr oxima tion t o it a waits fut ur e research on th e problem of adjusting

values for changes in credit quality of information-problematic borrowers along the

lines of Berger et al (1991) an d J ones an d King (1995).

Ho w S h o u l d t h e C a p i t a l R a t i o De n o m i n a t o r B e Me a s u r e d ?

The measurem ent of capita l for th e nu mera tor of th e capital ra tios is only half

of the problem, indeed, perhaps the easier half. Capital adequa cy depends on t he r at io

of capit al to th e risk it should be prepa red to absorb. Thu s, th e denominat or of a

regulatory risk-based capital ratio should measure the bank's risk exposure, or the

var iabilit y of a ban k's net worth . There is disagreement over which mea sure of net

worth is most appropriate, but we prefer the `regulatory value of equity' measure

described above -- the market values of all as set s less th e values of liabilities adjust ed

for limited liabilit y. The grea ter t he var iability, the h igher capita l must be t o protect

aga inst th e social costs of ban kr upt cy.

In practice, however, it is difficult to develop an accurate measure of risk


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The Basle Committee also proposed a procedure for taking market risk into account and24

guidelines for measuring exposure to interest rate risk. To date, U.S. regulators have been

unable to agree on a procedure for incorporating concentration risk and interest rate risk in the

requirements. However, the European Union has already incorporated market risk into its

capital requirements (Szeg 1995).

exposure th at is reasona bly simple an d can be uniformly applied across bank s. The

Basle Accord's risk-weighted assets denominator (RWA) focuses on credit risk,

reflecting the perception that credit risk poses the most serious threat to bank

solvency. Other types of risk are to be incorporated lat er. All assets a nd off-balan ce24

sheet instrument s are as signed r isk weight s of 0%, 20%, 50%, or 100%, depending on

the group to which the obl igor belongs an d th e type of financial inst ru men t. The risk

weights do not reflect some obvious det erm ina nt s of credit r isk, such as d ifferences in

credit quality across commercial loans (all of which are in the 100% category),

concent ra tions of risk in a s pecific asset category or t o a par ticular obligor, indu str y,

or region, a nd covarian ces a mong th e values of finan cial instr um ents.

Several empirical studies have ana lyzed the correspondence o f RWA with actu al

ris k . Avery and Berger (1991b) an d Brad ley et al (1991) found th at RWA for bank s

and t hrifts, r espectively, was positively relat ed to th e pr obability of failur e and some

account ing measures of risk, but t hese rela tionships were fairly weak . Moreover, th e

relat ive risk weights in RWA were often out of alignmen t with actu al risk.

Cordell and King (1995) below obtain similar results, but use an entirely

different methodology. They app ly option pr icing met hods to ma rket da ta on publicly

traded banks and thrifts to measure their risks, making several technical improve-

ments to this literatur e. After measuring the value of the deposit insuranc e put option,


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they determine the capital ratio for each institution needed so th at th e value of th e put

option equals the existing flat-rat e deposit insur ance prem ium prevailing at th at time.

They find numerous problems with the relative risk weights for both ba nk s and th rifts,

and also conclude that acco un ting mea sur es of capita l may oversta te t he actua l value

of capita l tha t is available to absorb losses.

J ones and King (1995) below show tha t RWA can be imp roved by increasin g th e

risk weights on a ssets th at ar e classified as substa nda rd, doubtful, or loss by bank

examiners. Greater quant ities of classified assets incre ase t he va riance of fut ur e ban k

losses a s wel l as ra ising th e expected value of fut ur e losses. Thu s, by giving more

weight t o class ified as set s, a m odified RWA is likely to be closer t o our idea l denomi-

na tor -- t he var iability of net worth . Their simula tion of th e effects of th e prompt

corrective action rules of FDICIA described above yielded an even better tradeoff

between Type 1 and Type 2 errors when the RWA capital ratio denominator was

modified to give higher weights t o classified assets . Tha t is, the policy tra deoff was

improved more th an when just t he capital nu mera tor was adjusted t o take classified

assets into account.

Anoth er potential pr oblem with an y regulatory measu re of risk exposure used

as a denom inator is that it may be subject t o manipulation by bank man agement.

Banks may be able to restructure their transactions to reduce their capital

requ ir ements without r educing their actua l risk exposur es. Merton (1995) below

provides an example of how th e cur ren t RWA denomina tor can be circumvent ed -- in

place of a portfolio of mortgages, a ban k can hold th e economic equiva lent of th e same


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portfolio at a r isk weight one-eight h as large. The extent of such manipulat ion th at

has taken place since impleme nt at ion of RBC is an open quest ion for futu re r esear ch.

Thus, the denominator of the Basle Accord RBC capit al r at io appear s t o reflect

t he va r iability of net wort h or the economic value of equity quite imper fectly. Re-

searchers h ave suggested some practical ways to improve th e denomina tor. But the

more fundamenta l problem, as Merton (1995) argues below, is tha t we need a new kind

of risk a ccounting' focused on exposures rather t han values, that would captu re how

values ar e likely to cha nge in r esponse t o cha nges in t he u nderlying environment .

Alte rn a t ives to a S imple Risk-Based Cap i ta l Ra t io

The foregoing discussion implies that a simple risk-based capital ratio is a

rela tiv ely blunt t ool for cont rolling bank risk-ta king. The capita l in t he nu mera tor

may not always cont rol bank moral ha zard incentives, it is difficult to measur e, and

its m ea sured value may be subject to ma nipulat ion by `gains trading'. The risk

exposur e in th e denomina tor is also difficult t o mea sur e, corresponds only weakly to

actu al risks, and ma y be subject to significan t ma nipulat ion. These imprecisions

worsen th e social tra deoff between the extern alities from bank failures an d th e

quan tity of bank interm ediation. To keep bank r isk to a tolera ble level, capita l

standards must be higher on average tha n they otherwise would be i f the capita l rat ios

could be set more precisely, rai sing ban k costs an d r educing th e am oun t of int ermedi-

at ion in th e economy in t he long ru n.

A way t o r esolve th ese problems a t least part ially is to have multiple capita l

ratios. F or example, it m ay be desira ble to have a minimu m sta nda rd with equity in


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the numerator and a separate standard with subordinated debt in the numerator

becau se ea ch ha s differen t benefits an d deficiencies. This is similar t o th e cur ren t

Basle Accord standards, which have minimums for Tier 1 capital (which contains

equity) and Tota l cap ita l (which cont ains both equ ity and subordin at ed debt). Avery

and Berger's (1991b) ana lysis suggested the both of these rat ios had ind ependent value

in captu ring risks. Analogously, an additional denominat or may catch some risks th at

are otherwise missed by the risk-based denominator and make it more difficult to

ma ni pulat e th e system. The leverage requirement for U.S. bank s, which requires a

minimum amount of capital per u nit ofu n w e i g h t e d assets, ma y be viewed as such a

response to problems with the risk-based rat ios. Avery an d Berger's (1991b) da ta also

suggested tha t the addition of the leverag e requ iremen t would impr ove the correspon-

dence between risk and the regulatory capital standards, provided that this

requirement is set high enough to be binding. However, th e leverage requiremen t is

imperfect as well. Merton (1995) shows tha t t he sa me tr an saction can be financed in

two different ways tha t lead to strikingly different leverage rati os, but do not affect th e

net worth or risk of the bank. Moreo ver, if th e ra tio is set t oo high, t he exten t of ban k

interm ediation m ay be inappr opriat ely constr ained.

Kane (1995) below argues that regulatory capital requirements ar e an ineffi cient

mean s of cont rolling th e government 's risk as u ninsur ed creditor becau se regulators

do not limit risk exposure a s rigorously as private ent ities would. The weaker th e

ability of regulators to identify, measure, and control risk-taking by depository

institut ions, the more burdensome capital requirements must be i n order to protect t he


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See Litan (1987), Pierce (1991), and Szeg (1994) for extended analysis of the narrow25

bank.

government 's claim as un insured creditor. Kane cont ends tha t th e same degree of

protection cou ld be at ta ined at lower cost by ma king great er u se of tr an spar ency an d

oth er loss cont rol mechanisms in addition to capita l requirements. He advocat es

privatizing some of the monitoring and disciplinary activi ties t ra ditiona lly under ta ken

by government through making broader use of risk-sharing contracts -- not only

subordinated debt as above, but a lso collat era lizat ion, coinsu ra nce, and r einsu ra nce --

to enlist the greater accountability and quicker responsiveness of private entities in

cont rolling ban k r isk ta king.

Miller (1995) below advocates scrapping capital requirements and official

surveillance of risk in favor of a `narrow bank' in which insured deposits must be

investe d only in short-term Treasury bills or close equivalents. Banks would also25

issue non-guaranteed securities to fund conventional bank loans, just as finance

compa nies an d leasing compan ies now do. Altern at ively, most of th e benefits of th e

transparency and simplicity of this approach could be maintained while allowing

greater flexibility in port folio choice if bank s a re perm itt ed t o hold not only short-ter m

Treasuries, but also oth er a ssets t ha t ar e regularly tr aded on well-organ ized ma rkets

an d can be ma rked t o ma rket da ily. This could be implemented in t wo ways which

differ according to whet her or not insu red deposits ar e kept in a s epar at e legal ent ity

of a diversified banking corporation: 1) the `secure depository' approach, in which

institut ions would be required to form separ at ely incorpora ted en tit ies tak ing insur ed

deposits and holding only permiss ible, ma rketa ble asset s; or (2) the `secur ed deposits'


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appr oach, in wh ich in sur ed deposits secur ed by a lien on a pool of perm issible asset s

would be in a corporat e entity holding other a ssets an d liabilities (Benst on et al 1989).

Capital requirements for the `secure depository' (or the analogous excess collateral

requirements for `secured deposits') would be set to insure that the chance of

insolvency between daily mark-to-market points is reduced to some minimal

pr obab ility with very low expected losses. These appr oaches sha re with Kan e's

proposal an empha sis on greater r eliance on private sector mechan isms for ident ifying,

measuring, and monitoring risk-taking by banks -- in effect, greater relia nce on m ar ket

capital `requirement s' ra th er tha n regulatory capita l requirement s.

VI . U n in t e n d ed C on s eq u e n ce s of Re gu la t or y C a p it a l Re q u ir e m e n t s

Since actual capital standards are, at best, an approximation to the ideal, it

should not be surprising that they may ha ve had some u nint ended effects. Ea rlier we

noted tha t in response to an increase in its required equity-to-asse t r at io, a ba nk might

increase its port folio risk an d raise its probability of failur e. Risk-based capita l

requirements that penalize increases in portfolio risk can reduce such unintended

cons equ en ces of capita l requirement s, but as we have seen, these sta nda rds ar e

imp recise, leaving open t he possibility tha t some ban ks ma y increase portfolio risks

whe n capital sta nda rds ar e raised. Moreover, imperfections in setting th e level of

required capital and the relative risk weights may lead to allocative inefficiencies if

capital requirements distort relative prices bo th am ong bank s an d between ba nk s an d

non-bank competitors, and divert fin an cial r esources from t heir most pr oductive uses.

In this section, we focus on two specific areas in which regulatory capital


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requirements m ay h ave ha d un intended effects on ban k portfolio risk a nd/or creat ed

a llocative inefficiencies. These a re (1) th e explosive growth of secur itization in t he

1980s, and (2) the so-c

the role of capital in financial institutions

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