Estimating the impact of higher capital requirements on the cost of equity: an empirical study of European banks

Abstract

The new regulatory framework imposes an increase in capital requirements for banks. Although core capital (equity) is more expensive than other liabilities (debt), it strengthens banks’ stability and improves its loss-absorbing capacity. In this paper, we investigate the link between high-quality capital requirements and systematic risk. We further analyze the extent to which an improvement in the quality of the banks’ balance-sheet will affect the expected return on equity. We show the impact of shifts in funding structure on information asymmetries (especially implicit guarantees) and on the average funding cost. Our results demonstrate that core capital is essential for increasing banks stability and for reducing the average funding cost for banks. Our empirical analysis provides support for the introduction of strengthened prudential requirements defined in Basel III.