Capital-Risk Decisions and Profitability in Banking: Regulatory versus Economic Capital

39 Pages Posted: 23 Jun 2008

See all articles by Phong T. H. Ngo

Phong T. H. Ngo

Australian National University (ANU)

Date Written: June, 23 2008

Abstract

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

Ngo, Phong T. H., Capital-Risk Decisions and Profitability in Banking: Regulatory versus Economic Capital (June, 23 2008). 21st Australasian Finance and Banking Conference 2008 Paper, Available at SSRN: https://ssrn.com/abstract=1150067 or http://dx.doi.org/10.2139/ssrn.1150067

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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