A Theory of Precautionary Regulatory Capital in Banking

30 Pages Posted: 9 Jan 2008

See all articles by Phong T. H. Ngo

Phong T. H. Ngo

Australian National University (ANU)

Abstract

The orthodox assumption in the banking literature is that capital requirements are a binding constraint on banking behavior. This is in conflict with the empirical observation that banks hold a buffer of capital well in excess of the minimum requirements. This paper develops a model where capital is endogenously determined within a profit-maximizing equilibrium. Optimality involves balancing the reduction in expected costs associated with regulatory breach with the excess cost of financing from increasing capital. We demonstrate that when the equilibrium probability of regulatory breach is less than one-half, banks are expected to hold precautionary capital.

Suggested Citation

Ngo, Phong T. H., A Theory of Precautionary Regulatory Capital in Banking. International Review of Finance, Vol. 6, No. 3-4, pp. 99-128, September/December 2006, Available at SSRN: https://ssrn.com/abstract=1081721 or http://dx.doi.org/10.1111/j.1468-2443.2007.00061.x

Phong T. H. Ngo (Contact Author)

Australian National University (ANU) ( email )

RSFAS, College of Business and Economics
Australian National University
Canberra, Australian Capital Territory 0200
Australia
+61 2 6125 1079 (Phone)

HOME PAGE: http://cbe.anu.edu.au/people/rsfas/phong-ngo/

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