How Have Banks Managed Their Capital – A Ratio Decomposition Analysis
This paper is motivated by the conflicting evidence in prior bank capital structure literature and the lack of resilience of bank capital to the current financial crisis of 2007-2010. The paper analyzes the reaction of banks’ asset portfolio and capital structure to adverse changes of regulatory capital ratios. Based on management discretionary decisions pertaining to balance sheet items, I question whether banks respond to declines in tier 1 and total regulatory capital ratio through gaming the leverage ratio or though the risk-weighted assets.
The paper employs a ratio decomposition approach, where the regulatory ratio is broken down to its components of leverage along with detailed positions in various risk-weighted asset classes. I also examine whether asset risk weighting is effective in measuring the degree of bank riskiness. Therefore, I test whether response of bank managers to declines in regulatory capital changes through risk-weighted assets is associated with other measures of risk. Finally, I conjecture that managers use discretion to manage regulatory capital through changes of asset positions and classification to relevant risk classes.
1. Background and Motivation
Looking at the contradictory results of prior research on bank capital structure, banks seem to face conflicting goals emanating from shareholders, debt holders and regulators (Gropp and Heider, 2009). Shareholders aim at maximizing the return on the equity invested. Therefore, they implicitly get along with as small equity capital as feasible to achieve their objective. Debt holders have different goals to minimize the riskiness of assets as opposed to raising new equity capital. Finally, regulators insist on banks holding greater equity capital to act as a buffer against declines in asset values and for soundness and general economic health reasons.
The question of how much leverage banks need has been urging academic and regulatory efforts. A more stimulating question has been why banks are highly leveraged institutions despite the acclaimed irrelevance proposition of Modigliani and Miller (1958), hereinafter MM. In an MM world, the firm’s leverage is irrelevant to total cost of capital. Consequently, banks should not manage risk as shareholders hold a well-diversified portfolio that adjusts for risk. Nonetheless, regulatory efforts have strived to cap the soaring leverage of financial institutions for soundness and safety reasons. MM postulated that a rise in leverage generates offsetting changes in the cost and risk of capital in a frictionless world. Since banks are highly leveraged financial institutions, such effect is obviously spelled. Therefore, the risk-adjusted cost of capital is unchanged.
This research is motivated by the conflicting evidence provided by prior bank capital structure literature. Market-discipline-type research conjectures that regulation is only...