A bank's optimal capital ratio: A time-varying parameter model to the partial adjustment framework

Abstract

We extend the existing literature on bank capital structure by applying a time-varying parameter model to the partial adjustment framework. This model allows one to obtain a more timely and on-going assessment of bank behavior in adjusting the capital ratio to its optimal or target level. The estimated time-varying rate of capital adjustment indicates that banks slowly adjusted their capital ratios to their optima or targets before the 2007–2009 global financial crisis, while they more rapidly adjusted their capital ratios upwards after the crisis. This finding suggests that banks make faster capital structure adjustments under more stringent post-crisis regulatory reforms of capital requirements. Moreover, we find convincing evidence on a structural change in bank behavior in adjusting its capital ratio around the global financial crisis.