MARKET TESTS OF CAPITAL ADEQUACY OF LARGE COMMERCIAL BANKS

Abstract

FOR AS LONG as the public record has exposed bank supervisory policy, bank supervisors have wanted more capital for commercial banks. Sixty years ago, in the first-known explicit statement on capital policy, the Comptroller of the Currency, John Skelton Williams, stated a long well-known but now forgotten standard for bank capital: one dollar of capital to ten dollars of deposits.' The standards suggested by the supervisors have seldom been met in practice. Declines in bank capital adequacy ratios usually occurred during periods of more than average economic and banking growth [20]. Faced with an accomplished decline in capital, the supervisors then usually retreated from their former position and took up new ones, only to be left behind again in the next great period of banking growth. The bank structure has recently passed through such a period and the decline of bank capital has been lamented by Chairman Burns [4]. One explanation of the disparity between supervisory standards and the defacto levels of bank capital may have been that the supervisors were out of touch with the standards of safety required by the money and capital markets. Investors in the capital markets are constantly assessing the risk-return relationship of bank obligations which are subordinate to deposits issued by the larger banks. Bank managers, responding to these signals from the market, attempt to implement optimizing capital policies which will minimize the total cost of funds. The question to which this study is directed is the sensitivity of the capital market to differential bank capital standards established by managerial and regulatory policy. Does the capital market require differential risk premiums on unsecured obligations issued by large banks which have different capital positions? If there is no relationship between the risk premiums required by the market and the capital position of the issuing banks, capital must be adequate or perhaps abundant for the perceived risk in these investments. Yet, if the market demands significant risk premiums which are a function of the banks' capital position, these banks are approaching a level where the market is questioning the adequacy of their capital. Perhaps the market for unsecured obligations of large banks can provide an early warning system to alert bank investors and regulators about the capital adequacy levels of these banks. This study reports on three tests: one test on the capital notes sold in competitive capital markets by large banks and two tests on the equity shares of large banks