Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Regulating Bank Capital Structure to Control Risk

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Regulating Bank Capital Structure to Control Risk

Article excerpt

The most important recent developments in bank regulation are based on capital requirements. For example, the Basle Accord of 1988 specifies that bank capital must be at least 8 percent of a bank's risk-weighted assets.1 Also, the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) requires regulators to shut down a bank whose capital has dropped below a cutoff level.

While these regulations are important, their focus is too narrow in that they concentrate solely on equity. There are other types of financial instruments available, and these can be even more effective than capital requirements at controlling risk. Proposals to require banks to issue subordinated debt recognize this, but even those proposals do not make full use of the possibilities available. This article argues that capital regulation can be improved by using financial instruments like convertible debt and warrants with high strike prices. Furthermore, some of the improvement brought about by these instruments would allow a reduction in the traditional capital requirements.

Any economic study of bank capital regulation requires a theory of capital structure. Modern theories of corporate financial structure start with the celebrated result of Modigliani and Miller (1958): that in a world without taxes or bankruptcy costs, the value of a firm does not depend on its capital structure. These theories then consider departures from the world of Modigliani and Miller-departures that cause the capital structure to matter. The particular departure studied in this article is agency theory. In the agency theory of capital structure, limited liability creates an incentive for highly leveraged firms to take excessive risk. These incentives are made worse in banking because of deposit insurance. This idea was developed by Merton (1977) and Kareken and Wallace (1978) in the context of deposit insurance and is related to the agency theory of capital structure developed by Jensen and Meckling (1976).2

The analysis presented in this article is a simplified exposition of the analysis contained in Marshall and Prescott (2001). They examine the value of augmenting capital regulations with securities that fine-tune the payoff received by a bank. In the Marshall and Prescott model, a bank chooses the risk and mean characteristics of its loan portfolio. For reasons described later, limited liability and government insured bank debt gives banks an incentive to take risk. They find that capital requirements are much more effective at controlling risk taking if they are augmented with securities like warrants or convertible debt. As in Green (1984), these latter instruments control risk taking because they lower the net return to a bank when it performs extremely well.

The present article's focus on controlling risk taking is particularly relevant to banking. The most striking example of a failure to control risk-taking incentives is the savings and loan crisis of the 1980s. The standard story told about this event is that the inflation of the 1970s lowered the value of the savings and loans' fixed rate mortgages to the point that many had a negative net worth. Because of this negative net worth, the savings and loans had nothing to lose by taking on lots of risk. The deregulation of the early 1980s gave the savings and loans the opportunity to take on the risk, and many failures throughout the 1980s resulted.3

There is additional evidence of excessive risk taking. Boyd and Gertler (1994) argue that large banks, who had stronger deposit insurance protection due to the "too big to fail" doctrine, took more risk than smaller banks during the late 1980s, which was a period of widespread banking problems. Other studies have found a connection between low capital levels and bank risk. The survey in Berger, Herring, and Szego (1995) lists studies that imply that a higher capital ratio is associated with lower bank risk, though this relationship is sometimes weak. …

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