The Formation of Hidden Negative Capital in Banking: A Product Mismatch Hypothesis

Abstract

This paper investigates hidden negative capital (HNC) in banks. We develop a simple theoretical model that links HNC to assets charge-offs and shows how product mismatch raises the HNC. In the empirical part, we further test the product mismatch hypothesis using unique data on HNC for U.S. and Russian banks. To address sample selection and endogeneity issues, we apply the Heckman selection approach with instruments. Our results indicate that in both countries product mismatch causes formation of HNC and, conditionally on selection, increases its size. Our results may facilitate improvements in the prudential regulation of banking activities in different countries.