Capital-Risk Decisions and Profitability in Banking: Regulatory versus Economic Capital
39 Pages Posted: 23 Jun 2008
Date Written: June, 23 2008
I model the capital-risk-profit relation in a simultaneous three-equation model. The results show no systematic relation between risk and profit which is consistent with the view that risk is chosen optimally. Taking this as given, the equilibrium relation between capital and profit depends on the definition of capital. First, the evidence suggests that banks manage regulatory capital to maximise profit - leading to no systematic relation between regulatory capital and profit. Second, capital regulations divert banks' attention away from and/or limit their ability to manage economic capital - leading to a significant negative relation between economic capital and profit. Taken together, these findings explain why banks begrudge regulators for setting capital limits yet continue to hold regulatory capital well in excess of minimum requirements.
Keywords: Banking, profitability, capital, risk, endogeneity
JEL Classification: G21, G28, L25
Suggested Citation: Suggested Citation