Why Do Banks Hold Capital in Excess of Regulatory Requirements? A Functional Approach
IWH Discussion Paper No. 192
23 Pages Posted: 20 Jul 2004
Date Written: 2004
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: Suggested Citation