Target Capital Ratio and Optimal Channel(s) of Adjustment: A Simple Model With Empirical Applications to European Banks

Abstract

Why do banks decide to reach their target capital ratio by selling assets and/or issuing new shares when each channel of adjustment is costly? We offer a simple framework to answer this question in which the aim of the bank is to minimize the total adjustment cost subject to the target's constraint and we derive its optimal strategy. We then compare our model's predictions to the decisions taken by two systemic banks to issue new shares in 2017 and for which the target ratio was publicly disclosed. Predictions are consistent with the observed decisions. Smaller banks are also considered.

Keywords: Equity Issuance, Asset Sale, Price Impact, Target Capital Ratio, Large Banks

JEL Classification: G21