Bank Capital and Public Regulation

Abstract

THE ADEQUACY OF COMMERCIAL BANK capital is being questioned anew as a result of recent turmoil in financial markets. The basic issue is one of conflicting private and public interests: will banks voluntarily maintain sufficient capital to protect against bank failures, or is some form of regulatory coercion necessary?1 Critics (e.g. [6]) point to the secular decline in banks' capital-to-asset ratios, emphasis on liability management, and diversification via holding companies into previously proscribed activities as symptomatic. But the nature and extent of the alleged conflict remain obscure. Previous discussions have emphasized two functions of bank capital: as a source of funds, enabling banks to purchase earning assets, and as a cushion absorbing fluctuations in asset values. As a source of funds, bank capital is seen as yielding benefits primarily to shareholders. Like deposits or any other source of funds, equity allows the bank to purchase earning assets, and if these are expected to yield more than the cost of capital, the net benefit will accrue to the shareholders. In addition, since capital has indefinite term-to-maturity, it can reduce the bank's exposure to high borrowing costs and disintermediation