Why Do Banks Hold Capital in Excess of Regulatory Requirements? A Functional Approach

IWH Discussion Paper No. 192

23 Pages Posted: 20 Jul 2004

See all articles by Diemo Dietrich

Diemo Dietrich

Newcastle University Business School

Uwe Vollmer

University of Leipzig

Date Written: 2004

Abstract

This paper provides an explanation for the observation that banks hold on average a capital ratio in excess of regulatory requirements. We use a functional approach to banking based on Diamond and Rajan (2001) to demonstrate that banks can use capital ratios as a strategic tool for renegotiating loans with borrowers. As capital ratios affect the ability of banks to collect loans in a nonmonotonic way, a bank may be forced to exceed capital requirements. Moreover, high capital ratios may also constrain the amount a banker can borrow from investors. Consequently, the size of the banking sector may shrink.

Keywords: Incomplete contracts, minimum capital requirements, bank capital, disintermediation, pro-cyclicality

JEL Classification: G21, G28

Suggested Citation

Dietrich, Diemo and Vollmer, Uwe, Why Do Banks Hold Capital in Excess of Regulatory Requirements? A Functional Approach (2004). IWH Discussion Paper No. 192, Available at SSRN: https://ssrn.com/abstract=562723 or http://dx.doi.org/10.2139/ssrn.562723

Diemo Dietrich (Contact Author)

Newcastle University Business School ( email )

5 Barrack Road
Newcastle-upon-Tyne NE1 7RU, NE1 4SE
United Kingdom

HOME PAGE: http://www.ncl.ac.uk/business-school/staff/profile/diemodietrich.html

Uwe Vollmer

University of Leipzig ( email )

Marschnerstrasse 31
D-04109 Leipzig, 04109
Germany

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