A Theory of Precautionary Regulatory Capital in Banking*

Abstract

ABSTRACTThe orthodox assumption in the banking literature is that capital requirements are a binding constraint on banking behavior. This is in conflict with the empirical observation that banks hold a buffer of capital well in excess of the minimum requirements. This paper develops a model where capital is endogenously determined within a profit‐maximizing equilibrium. Optimality involves balancing the reduction in expected costs associated with regulatory breach with the excess cost of financing from increasing capital. We demonstrate that when the equilibrium probability of regulatory breach is less than one‐half, banks are expected to hold precautionary capital.