The Relationship between Capital and Earnings in Banking
Posted: 16 Sep 1999
Date Written: February 1994
Contrary to conventional wisdom, bank capital-asset ratios are positively related to returns on equity in the 1980s. We find that higher capital Granger-causes higher earnings and vice versa using data on U.S. banks, 1983-1989. The Granger-causation from earnings to capital suggests that banks often retain marginal increases in earnings, which is not surprising. The positive Granger-causation from capital to earnings, which is surprising, occurs primarily through lower interest rates paid on uninsured purchased funds. This is consistent with the hypothesis that expected bankruptcy costs for banks increased substantially in the 1980s, raising optimal capital ratios.
JEL Classification: G21
Suggested Citation: Suggested Citation