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Banking Competition and Capital Ratios

IMF Working Paper No. WP/07/216

European Financial Management, Forthcoming

36 Pages Posted: 28 Mar 2010  

Martin Čihák

International Monetary Fund (IMF)

Klaus Schaeck

University of Bristol

Multiple version iconThere are 3 versions of this paper

Date Written: March 28, 2010

Abstract

Empirical studies provide evidence that bank capital ratios exceed regulatory requirements. But why do banks maintain capital levels above regulatory requirements? We use data for more than 2,600 banks from 10 European countries to test recent theories suggesting that competition incentivizes banks to maintain higher capital ratios. These theories also predict that banks that engage in arm’s length lending have lower capital ratios, and that shareholder rights and deposit insurance characteristics affect capital ratios. Consistent with these theories, our evidence robustly indicates that competition increases capital holdings. Banks that lend at arm’s length exhibit lower capital ratios, whereas banks in countries with strong shareholder rights operate with higher capital ratios. We also show some evidence that generous deposit protection schemes that exclude non-deposit creditors are associated with higher capital ratios. Our results have important policy implications. First, while the traditional view suggests imposing restrictions on bank activities in order to restrain competition, our analysis indicates the opposite, even after adjusting the regressions for risk-taking. Second, weak shareholder rights undermine market forces that would otherwise encourage banks to hold higher capital ratios.

Keywords: Bank Capital, Regulation, Competition, Deposit Insurance, Shareholder Rights

JEL Classification: G21, G28, L11

Suggested Citation

Čihák, Martin and Schaeck, Klaus, Banking Competition and Capital Ratios (March 28, 2010). IMF Working Paper No. WP/07/216; European Financial Management, Forthcoming. Available at SSRN: https://ssrn.com/abstract=1579625

Martin Cihak

International Monetary Fund (IMF) ( email )

700 19th Street N.W.
Washington, DC 20431
United States

Klaus Schaeck (Contact Author)

University of Bristol ( email )

University of Bristol,
Senate House, Tyndall Avenue
Bristol, BS8 ITH
United Kingdom

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