Abstract
We study optimal bank capital choice as a dynamic tradeoff between the opportunity cost of equity, the loss of franchise value following a regulatory minimum capital violation, and the cost of recapitalization. We introduce a recapitalization delay, which results in a strictly positive probability of capital adequacy violation and qualitatively influences optimal capital raising policies. We calibrate the model to bank accounting return data and evaluate the model's ability to explain observed bank capital ratios. Differences in return volatility explain a significant fraction of the cross-sectional variation in bank capital ratios. Differences in the level of capital market imperfections across banks constitute a secondary explanation. Our analysis points to the need for improved forward looking estimates of bank return volatility.
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