The Inventory Perspective on Bank Capital

Abstract:     
This paper models bank capital management assuming illiquid assets, stochastic cash flow, and fixed costs of equity issue. Banks with sufficient franchise value (expected cash flow) maintain a buffer of capital in excess of regulatory requirements. The desired buffer is a non-monotonic function of franchise value. Incentives for risk taking depend upon this buffer not the absolute level of capital. Capital requirements have little long run effect on bank risk-taking. Negative cash flow and higher capital requirements reduce bank lending and risk-taking, with greatest impact on severely undercapitalized banks. Risk-preference and looting emerge under random audit.

Keywords: Capital buffers, capital regulation, capital dynamics, capital management, capital structure, cash flow, endogenous capital, financial distress, franchise value, looting, moral hazard, transaction costs

JEL Classifications: G21

Working Paper Series