ASLI DEMIRGUC-KUNT
ENRICA DETRAGIACHE
OUARDA MERROUCHE
Bank Capital: Lessons from the Financial Crisis
Using a multicountry panel of banks, we study whether better capitalizedbanks experienced higher stock returns during the financial crisis. We differ-entiate among various types of capital ratios: the Basel risk-adjusted ratio,the leverage ratio, the Tier 1 and Tier 2 ratios, and the tangible equity ra-tio. We find several results: (i) before the crisis, differences in capital didnot have much impact on stock returns; (ii) during the crisis, a strongercapital position was associated with better stock market performance, mostmarkedly for larger banks; (iii) the relationship between stock returns andcapital is stronger when capital is measured by the leverage ratio rather thanthe risk-adjusted capital ratio; (iv) higher quality forms of capital, such asTier 1 capital and tangible common equity, were more relevant.
JEL codes: G21, G28Keywords: bank capital, financial crisis, Basel capital accord.
SINCE THE FIRST BASEL capital accord in 1988, the prevailingapproach to bank regulation has put capital at front and center: more capital shouldmake banks better able to absorb losses with their own resources, without becominginsolvent or necessitating a bailout with public funds. In addition, by forcing bankowners to have some “skin in the game,” minimum capital requirements shouldcurb incentives for excessive risk taking created by limited liability and amplifiedby deposit insurance and bailout expectations. Over the last 20 years, regulatorycapital requirements have been refined and broadened to cover various types of risk,differentiate among asset classes of different risk, and allow for a menu of approachesto determine the risk weights to be applied to each asset category. In the process,
The views expressed in this paper are those of the authors, and should not be attributed to the WorldBank, the International Monetary Fund, or the European Securities and Markets Authority. We thank StijnClaessens, Martin Hellwig, Noel Sacasa, and seminar participants at Williams College, Chicago FederalReserve Bank Structure Conference, and the IMF Institute for useful comments.
ASLI DEMIRGUC-KUNT is Director of Research, the World Bank (E-mail: [email protected]). ENRICA DETRAGIACHE is Senior Advisor, European Department at the IMF (E-mail:[email protected]). OUARDA MERROUCHE is Program Manager, Graduate Institute of International andDevelopment Studies, Geneva (E-mail: [email protected]).
Received October 20, 2011; and accepted in revised form April 19, 2012.
Journal of Money, Credit and Banking, Vol. 45, No. 6 (September 2013)C© 2013 World Bank
1148 : MONEY, CREDIT AND BANKING
the rules have become increasingly elaborate, reflecting the growing complexity ofmodern banking, but also the need to address ongoing efforts by regulated entities tocircumvent the requirements through financial innovation.1
While regulatory consensus has viewed capital as an essential tool to limit riskin banking, there has been less agreement among economic theorists. A number oftheoretical models bear out the relationship posited by regulators that minimum cap-ital requirements ameliorate the moral hazard created by deposit insurance (Furlongand Keeley 1989, Keeley and Furlong 1990, Rochet 1992), but others find that suchrequirements, by reducing the charter value of banks, have the opposite effect (Koehnand Santomero 1980, Kim and Santomero 1988). Calem and Rob (1999) reconcilesthese different views: in a dynamic model in which banks build up capital throughretained earnings, this paper shows that when capital is low relative to the regulatoryminimum banks choose a very risky loan portfolio to maximize the option value ofdeposit insurance. As capital increases and future insolvency becomes less likely, onthe other hand, incentives to take on risk are curbed by the desire to preserve thebank’s charter value. When banks are so well capitalized that insolvency is remote,an additional increase in capital induces banks to take on more risk to benefit from theupside. In this model, the relationship between bank capital and risk is U-shaped.2
The recent financial crisis undoubtedly demonstrated that existing capital regula-tion, in its design or implementation, was inadequate to prevent a panic in the financialsector, and once again governments around the world had to step in with emergencysupport to prevent a collapse.3 Many of the banks that were rescued appeared to bein compliance with minimum capital requirements shortly before and even duringthe crisis. In the ensuing debate over how to strengthen regulation, capital continuesto play an important role. A consensus is being forged around a new set of capitalstandards (Basel III), with the goal of making capital requirements more stringent.4
In this paper we evaluate the effectiveness of current capital regulations andtest existing theories that motivate the use of capital regulation to curb bank risktaking. If bank capital truly helps curbing bank risk-taking incentives and absorbing
1. See Caprio and Honohan (1999) for a discussion.2. Diamond and Rajan (2000) presents a theory of bank capital in a framework that also explains why
financial intermediaries exist. In this theory, capital helps bank deal with unexpected withdrawals fromdepositors, but increases ex post rent extraction from borrowers, which is undesirable ex ante. For a reviewof the literature on bank capital, see for instance Santos (2001).
3. See, for instance, Vinals et al. (2010), Caprio, Demirguc-Kunt, and Kane (2010), Demirguc-Kuntand Serven (2010), Hellwig (2010), and Merrouche and Nier (2010).
4. In July 2010, the Basel Committee agreed to introduce a Tier 1 leverage ratio of 3% on a trialbasis, and later on, in September 2010, it formulated new, strengthened risk-adjusted capital requirements.Specifically, the common equity ratio will increase from 2% to 4.5%, with an additional countercyclicalbuffer of 0–2.5% at the discretion of country supervisors. In addition, banks will be required to hold a“capital conservation” buffer of an additional 2.5% of common equity, bringing the total to 7%. The Tier1 capital requirement will increase to 6% from 4%, while the total risk-adjusted capital requirement willremain unchanged at the existing 8% level. Banks will be able to meet the difference between the totalcapital requirement and the Tier 1 requirement with Tier 2 capital. Definitions of various forms of capitalhave also become more stringent. Particularly, there will be stronger limits on the amount of intangiblecapital (mortgage servicing rights, deferred tax assets, minority interests). All changes will be phased ingradually, and the transition will have to be completed by 2019.
ASLI DEMIRGUC-KUNT, ENRICA DETRAGIACHE, AND OUARDA MERROUCHE : 1149
losses, we would expect that, when a large, unexpected negative shock to bankvalue materializes—as was the case with the financial crisis that began in August2007—equity market participants would judge better-capitalized banks to be in abetter position to withstand the shock, and the stock price of these banks would notfall as much as that of poorly capitalized banks.
A second question that we address in the paper is which concept of capital was morerelevant to stock valuation during the crisis. Existing capital requirements are set as aproportion of risk exposure; but if the risk exposure calculation under Basel rules didnot reflect actual risk, capital measures based on cruder risk-exposure proxies, suchas total assets, may have been considered as more meaningful by equity traders (Blum2007). The flaws of Basel I risk weights included the 50% risk weight for loans securedby mortgages, the zero risk weights on sovereign debt, and incentives to engage inregulatory arbitrage caused by the lack of differentiation among commercial loansof different quality. Critics of Basel II questioned the increased reliance on creditrating agencies to determine risk weights (given that rating agencies are paid bythe rated parties) and the reliance on banks’ own (internal) models, which are nottransparent and create problems of consistency between banks. Hellwig (2010) arguesthat Basel II risk calibrations, in particular under the model-based approach appliedby large banks, led to excessive indebtedness and maturity transformation through:(i) insufficient accounting of risks arising from correlations of credit risks betweenmortgage assets and derivatives and correlations between counterparty credit risks andunderlying risks in derivatives and other hedge contracts; and (ii) a poorly designedempirical basis for risk modeling that uses short times series, which exhibit substantialnonstationarity and does not account for the endogeneity of the risks involved. A thirdissue is the types of instrument that are counted as capital for regulatory purposes. Asrecognized by the Basel Committee on Banking Supervision (2009), under currentstandards some banks were able to show strong capitalization while holding a limitedamount of tangible common equity, which is the component of capital that is availableto absorb losses while the bank remains a going concern. In our regressions, we testwhether banks with higher quality capital were viewed more positively by equitymarket participants.
Because we use a panel of banks from several countries, in our tests we canuse country–time dummy variables to control for all country and time-specific fac-tors potentially affecting stock returns, including differences in interest rates andother macroeconomic variables, the severity of the financial crisis and its economicrepercussions across countries, different policy responses by the authorities, differ-ent quality of bank regulation and supervision, and differences in accounting andregulatory standards. This approach greatly reduces concerns about possible omittedvariables.
We find support for the hypothesis that better-capitalized banks experienced asmaller decline in their equity value during the crisis. However, the effect is large androbust only for a subsample comprising the larger banks. For this group, we also findthat stock returns during the crisis were more sensitive to the leverage ratio than tothe risk-adjusted Basel ratio, an indication that market participants may have viewed
1150 : MONEY, CREDIT AND BANKING
the risk-adjustment under Basel as uninformative during the crisis.5 Finally, we alsofind some evidence that Tier 1 capital was seen as the more relevant notion of capital,especially in the sample of larger banks.
Our paper is related to work by Estrella, Park, and Peristiani (2000) that tests howalternative capital ratios fared in predicting U.S. bank failures in the early 1990s,and finds that a leverage ratio performs just as well as a risk-adjusted measure ofcapital. Berger and Bouwman (2009) explore the relationship between bank capitaland different aspects of banks’ performance in crises and tranquil times for U.S.banks. Crises include both banking crises and stock market crashes. Among thetests is a comparison of excess stock returns on a portfolio of well-capitalized banksand one of poorly capitalized banks during the recession of the early 1990s andduring the recent subprime crisis. According to this study, better capitalized banksdid significantly better in the early 1990s, but not in the recent crisis. The study doesnot explore the potentially different role of alternative concepts of bank capital.
The paper is structured as follows. The next section presents the data and theempirical model. Section 2 contains the main results. Section 3 concludes.
1. SAMPLE SELECTION, DATA DESCRIPTION, AND EMPIRICAL MODEL
1.1 Sample Selection
We start with all the banks in the Bankscope database that are listed and hence havea stock price. We then exclude banks for which no information is available on capital.In addition, since we rely on intracountry variation to identify the relationships ofinterest, we exclude from the sample countries/dates for which we have less thanfive banks in the sample. The baseline sample includes a total of 381 banks in 12economies during the period Q1/2005–Q1.2009. Not all banks enter the sample inevery quarter, so the sample is unbalanced. The sample size in each quarter variesbetween 273 and 313.6 All the countries in the sample are advanced countries,7 andU.S. and Japanese banks dominate the sample. Note that the United States has beenslower to implement Basel II capital requirements than the other countries in oursample. In fact, in the United States the implementation of Basel II is still ongoingwhile in other countries implementation started at the end of 2006 for the simplermethodologies and completed at the end of 2007 for the advanced methodologies(Financial Stability Institute 2010).
The ratio of total assets of the banks in our sample to GDP varies between about144% (Hong Kong) and 18% (United States), with an average of 45% of GDP.
5. Throughout the paper we use interchangeably the terms “Basel ratio” and “risk-weighted capitalratio.”
6. Only two banks in our sample were closed down during our sample period (both of them U.S.banks), so attrition bias should not be a serious concern.
7. The sample comprises Canada, Denmark, France, Germany, Greece, Hong Kong, Italy, Japan,Norway, United Kingdom, and the United States.
ASLI DEMIRGUC-KUNT, ENRICA DETRAGIACHE, AND OUARDA MERROUCHE : 1151
Throughout the paper, we also show estimation results for a subsample includingonly very large banks, that is, banks with assets above US$50 billion. This sampleincludes a total of 91 banks from eight countries (with sample size in each quarterbetween 58 and 66 banks). It accounts for about 20% of the number of banks and65% of total assets of the full sample. The rationale for focusing on the largest banksis that typically these are the more sophisticated institutions that operate on a globalscale with complex balance sheets. Thus, these may be the banks with more opaqueassets and in a better position to skirt capital regulation through regulatory arbitrage.In addition, large banks are key to the stability of the system as a whole.
1.2 The Empirical Model
We estimate various version of the following basic equation:
yi j t =∑
j t
α j t d jt + β1(dnoncrisis ∗ ki j t−1) + γ 1(dnoncrisis ∗ Xi jt−1)
+β2(dcrisis ∗ ki j t−1) + γ 2(dcrisis ∗ Xi jt−1) + ui jt ,
where yijt is the bank’s stock return between the end of quarter t – 1, and the end ofquarter t calculated as log[RI(t)/RI(t – 1)], where RI is the Datastream return index:
RIt = RIt−1 ∗ P It
P It−1∗
(1 + DY
100 ∗ n
),
where PI is the price index, DY is the dividend yield of the price index, and n is thenumber of days in financial year. The αs, βs, and γ s are coefficients to be estimated;djt is a matrix of country/time dummy variables; kijt–1 is lagged bank capital, thevariables we are mostly interested in; and Xijt–1, is a matrix of bank-level controlvariables.8 Note that dnoncrisis is a dummy variable taking the value of 1 for thequarters preceding the financial crisis, that is, Q1.2006–Q2.2007, while dcrisis is adummy variable for quarters during which the financial crisis was unfolding, namely,Q3.2007–Q1.2009. Finally, uijt is a disturbance term.9 Through the interaction termwith the crisis dummy we allow the effect of the various explanatory variables onstock returns to differ during the crisis period.
The country/year dummy variables control for any possible omitted effect thatoperates at the country level, such as macroeconomic shocks, the systemic componentof the shock to bank equity prices, the policy response to the crisis, differences inaccounting and regulatory definition of capital across countries, and so on. In otherwords, what our model seeks to explain is just the cross-sectional, within-countrydispersion in stock returns in each quarter.
8. The test of serial correlation in the error term (as described in Drukker 2003) fails to reject the nullhypothesis of no serial correlation (p-value = 0.95).
9. For a similar empirical model relating stock returns during the financial crisis to firm characteristics,see Tong and Wei (2010).
1152 : MONEY, CREDIT AND BANKING
To isolate the effect of capital on this dispersion, we control for other bank-specificcharacteristics that may affect stock returns. Specifically, we control for bank liquidityusing liquid assets/assets; the bank’s reliance on deposits for funding (deposits/totalassets), asset quality (loans loss provisions/total assets), the banks’ business model(net loans/assets), and the bank size (log of total assets). Also, following standardasset pricing models, we include in the regression the stock’s beta (computed as the5-year covariance between the bank’s monthly stock return and the country stockmarket return) and the market-to-book value of equity.10 The price–earnings ratio(P/E) measure possible mispricing of bank equity during the boom.
Explanatory variables computed from bank balance sheet information, includingthe variables measuring bank capital, are available on a yearly basis rather than aquarterly basis, while our dependent variable is quarterly. For these variables, we usethe last available (but not contemporaneous) observation. For example, stock returnsduring each of the four quarters of 2007 are regressed on balance sheet variables atthe end of 2006. The model is estimated with ordinary least squares (OLS) estimates,and standard errors are clustered at the bank level to take into account possibleautocorrelation in the residuals.11
1.3 Overview of the Data
Table 1 shows summary statistics for the distribution of stock returns during thesample period for the full sample and for the sample of larger banks. Median quarterlystock returns are positive in the precrisis period and, as expected, become negative inthe third quarter of 2007, with a median quarterly decline of 2.6% in the full sampleand 3.5% in the sample of larger banks. Returns are also much more dispersed duringthe crisis than in tranquil times, with the standard deviation more than doubling. Thepost-Lehman quarters show even more negative stock returns and somewhat higherdispersion.
The main variable of interest is bank capital. As discussed in the Introduction,we use a number of alternative definitions of capital: (i) the risk-adjusted regulatorycapital ratio, calculated according to Basel rules—this is calculated as the sum of Tier1 and Tier 2 capital divided by risk-adjusted assets and off-balance sheet exposures;(ii) the Tier 1 regulatory ratio, which excludes Tier 2 capital from the numerator; (iii)the leverage ratio (defined as regulatory capital divided by total assets); (iv) the Tier1 ratio and Tier 2 leverage ratio; and (v) the tangible common equity ratio (definedas tangible equity divided by tangible assets). Tier 1 capital comprises shareholderfunds and perpetual, noncumulative preference shares. Tier 2 capital comprises hybridcapital, subordinated debt, loan loss reserves, and valuation reserves.
10. For a discussion of why it is desirable to include these variables directly in the regressions as firmcharacteristics rather than going through a factor model, see Tong and Wei (2010) and Whited and Wu(2006).
11. In unreported tests, we checked that clustering at the country level or by quarter (or both) does notchange the standard errors substantially.
ASLI DEMIRGUC-KUNT, ENRICA DETRAGIACHE, AND OUARDA MERROUCHE : 1153
TAB
LE
1
SUM
MA
RY
STA
TIS
TIC
S:C
API
TAL
RA
TIO
SA
ND
CO
NT
RO
LV
AR
IAB
LE
S
No.
ofob
serv
atio
nsM
ean
Std.
dev.
25th
perc
entil
e50
thpe
rcen
tile
75th
perc
entil
e95
thpe
rcen
tile
Full
sam
ple
Stoc
kre
turn
prec
risi
sQ
1.20
06–Q
2.20
071,
875
0.4
3.6
−1.
60.
32.
26.
1St
ock
retu
rncr
isis
Q3.
2007
–Q1.
2009
2,34
4−
3.5
7.8
−6.
7−
2.6
0.8
6.8
Stoc
kre
turn
post
-Leh
man
Q3.
2008
–Q1.
2009
1,01
3−
5.3
9.8
−10
.0−
4.8
0.4
8.9
RW
Rt
4,25
412
.62.
810
.711
.913
.719
.5R
WR
t14,
073
10.2
2.8
8.1
9.7
11.6
16.5
RW
Rt2
4,04
92.
31.
51.
22.
43.
14.
9L
Rt
3,77
98.
12.
55.
97.
89.
813
.0L
Rt1
3,81
46.
72.
44.
76.
38.
311
.4L
Rt2
3,72
61.
41.
10.
71.
31.
93.
4C
omm
oneq
uity
/RW
A3,
655
9.6
5.5
6.3
9.1
11.9
19.5
Com
mon
equi
ty/T
A5,
381
7.1
4.5
3.8
6.2
9.5
16.8
Oth
erca
pita
l/RW
A3,
654
1.2
3.3
−0.
60.
22.
28.
6O
ther
capi
tal/T
A3,
700
0.8
2.3
−0.
40.
11.
46.
0Ta
ngib
leeq
uity
/tang
ible
asse
ts5,
495
8.1
5.2
5.0
6.7
9.2
18.1
Mar
kett
obo
okva
lue
ofeq
uity
(PB
)4,
152
1.35
27.
897
1.01
71.
440
1.98
03.
078
Pric
e–ea
rnin
gsra
tio(P
E)
3,95
424
.537
149.
932
12.8
2515
.833
21.0
0038
.600
Bet
a4,
186
0.54
01.
090
0.24
30.
477
0.79
71.
487
Loa
nlo
sspr
ovis
ions
/TA
4,18
10.
234
0.24
50.
059
0.15
40.
329
0.86
3L
iqui
das
sets
/TA
4,15
67.
761
10.6
130.
118
2.84
310
.399
34.3
07To
tald
epos
its/T
A4,
195
73.3
6915
.359
63.7
0777
.242
87.2
7389
.929
Net
loan
s/TA
4,21
564
.289
14.4
8557
.830
66.8
4073
.940
83.4
30L
og(T
A)
4,21
916
.021
1.87
914
.561
16.2
6317
.429
18.6
59L
arge
bank
ssa
mpl
eSt
ock
retu
rnpr
ecri
sis
Q1.
2006
–Q2.
2007
340
0.8
3.0
−1.
20.
82.
46.
0St
ock
retu
rncr
isis
Q3.
2007
–Q1.
2009
480
−4.
78.
0−
8.0
−3.
50.
06.
7St
ock
retu
rnpo
st-L
ehm
anQ
3.20
08–Q
1.20
0921
1−
6.7
10.3
−11
.6−
5.8
−1.
08.
7R
WR
t88
712
.22.
410
.611
.713
.119
.5R
WR
t182
78.
61.
97.
28.
29.
512
.7R
WR
t282
73.
21.
52.
73.
34.
05.
2
(Con
tinue
d)
1154 : MONEY, CREDIT AND BANKING
TAB
LE
1
CO
NT
INU
ED
No.
ofob
serv
atio
nsM
ean
Std.
dev.
25th
perc
entil
e50
thpe
rcen
tile
75th
perc
entil
e95
thpe
rcen
tile
LR
t74
17.
22.
25.
46.
58.
512
.4L
Rt1
769
5.1
1.7
3.7
4.6
6.0
8.8
LR
t273
62.
01.
01.
31.
92.
83.
8C
omm
oneq
uity
/RW
A74
57.
23.
93.
47.
210
.513
.4C
omm
oneq
uity
/TA
973
4.8
3.3
1.9
4.1
7.5
10.7
Oth
erca
pita
l/RW
A74
51.
43.
3−
1.1
0.8
3.5
7.3
Oth
erca
pita
l/TA
748
0.7
2.0
−0.
60.
51.
94.
3Ta
ngib
leeq
uity
/tang
ible
asse
ts97
64.
52.
02.
94.
15.
98.
6M
arke
tto
book
valu
eof
equi
ty80
71.
601
2.31
91.
297
1.67
02.
157
2.93
9Pr
ice–
earn
ings
ratio
800
31.6
6929
5.39
911
.767
14.1
6717
.992
31.3
03B
eta
819
0.86
00.
488
0.49
20.
797
1.15
01.
850
Loa
nlo
sspr
ovis
ions
/TA
820
0.23
40.
213
0.07
30.
177
0.33
80.
679
Liq
uid
asse
ts/T
A82
09.
586
11.1
000.
779
4.35
516
.489
34.2
66To
tald
epos
its/T
A79
662
.089
17.2
8849
.131
62.6
0676
.183
88.8
89N
etlo
ans/
TA82
053
.105
16.1
2643
.873
54.6
3066
.195
74.2
10L
og(T
A)
820
18.4
290.
318
18.1
7418
.659
18.6
5918
.659
NO
TE
S:B
anks
inou
rsam
ple
oper
ate
in12
diff
eren
tOE
CD
coun
trie
s.T
hesa
mpl
epe
riod
fort
hem
easu
res
ofca
pita
l(la
gged
one
peri
odin
the
regr
essi
on)i
s20
05–2
008.
The
year
lyda
taar
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tain
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anks
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.RW
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eto
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esh
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isks
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ier
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atio
,defi
ned
assh
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plus
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etua
l,no
ncum
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ive
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ape
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ted
asse
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lanc
esh
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dun
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RW
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isth
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ier
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das
subo
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ated
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,hyb
rid
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rves
,and
valu
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-wei
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das
sets
and
off
bala
nce
shee
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ksm
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unde
rB
asle
rule
s.L
Rti
sth
ele
vera
gera
tiode
fined
asre
gula
tory
capi
tal
divi
ded
byto
tala
sset
s.L
Rt1
isth
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ier
1le
vera
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isth
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ier
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vera
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tio.O
ther
capi
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sal
lcap
itale
xclu
ding
com
mon
equi
ty.T
angi
ble
com
mon
equi
tyis
shar
ehol
der
fund
sm
inus
inta
ngib
leca
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l.T
hem
arke
tvar
iabl
es(s
tock
retu
rn,p
rice
–ear
ning
sra
tio,B
eta,
mar
ket-
to-b
ook
valu
eof
equi
ty)a
requ
arte
rly
fort
hepe
riod
Q1.
2005
–Q1.
2008
.The
sour
ceis
Dat
astr
eam
.The
beta
isde
fined
asth
em
easu
reof
anas
set’s
risk
inre
latio
nto
the
mar
ket;
itis
calc
ulat
edov
era
5-ye
arpe
riod
usin
gm
onth
lyob
serv
atio
ns.L
iqui
dity
incl
udes
trad
ing
asse
ts,a
ndlo
ans
and
adva
nces
with
am
atur
ityof
less
than
3m
onth
s.To
tald
epos
itsin
clud
esa
ving
san
dde
man
dde
posi
ts.T
Ast
ands
for
tota
lass
ets.
Sum
mar
yst
atis
tics
are
repo
rted
for
the
who
lesa
mpl
ean
dth
esa
mpl
eof
larg
eba
nks.
Lar
geba
nks
are
defin
edas
bank
sw
ithto
tala
sset
sab
ove
$50
billi
on(t
he20
thpe
rcen
tile
ofas
sets
).
ASLI DEMIRGUC-KUNT, ENRICA DETRAGIACHE, AND OUARDA MERROUCHE : 1155
Table 1 shows summary statistics on bank capital in our samples and sum-mary statistics for the other explanatory variables. For the full sample, the medianrisk-adjusted capital asset ratio was 11.9%, comfortably above the minimum Baselrequirement of 8%, with a standard deviation of 2.8%. Interestingly, larger banks hadlower capital than the full sample as measured by the tangible equity ratio (a medianof just 4.1%), the leverage ratio (a median of 6.5%), or the Tier 1 risk-adjusted ratio(8.2%). Thus, larger banks were relying more heavily on lower quality capital andhad larger “risk adjustments” of assets than smaller banks.
2. THE RESULTS
2.1 Results from the Baseline Model
Table 2 contains estimation results for the baseline model for the full sample and thesample of larger banks. The model allows the coefficient of all explanatory variablesto differ among the precrisis and crisis periods, and the table also reports tests for theequality of the crisis and precrisis coefficients.
Before the crisis, several of the explanatory variables appeared to significantlyaffect stock returns: banks with lower loan loss provisions, a higher market-to-bookratio, and a lower P/E ratio had higher stock returns. Also, among large banks moreliquidity was associated with higher returns. As for capital, there is some evidencethat higher capital (measured by the leverage ratio) resulted in higher stock returns inthe full sample, but the coefficient is small and the statistical significance is marginal.
During the crisis, the relationship between stock returns and bank characteristicschanged markedly. More reliance on deposit funding was rewarded by the stock mar-ket, not surprisingly given the disruptions in wholesale funding markets throughoutthe crisis. On the other hand, the standard liquidity ratio has a negative and significantcoefficient in one specification. Perhaps this reflects the fact that liquid assets wereassociated with holdings of mortgage-backed securities that were at the center of theasset quality deterioration and quickly became illiquid once the crisis started (BaselCommittee on Bank Supervision 2009). Also, liquidity during a crisis may capturethe extent of liquidity support by the Central Bank, a signal of trouble. The coefficientof loan loss provisions becomes much larger in the full sample, although it remainsinsignificant for the larger banks. The market-to-book ratio is no longer significantin the full sample.
Turning to capital, the Basel ratio is positive and (marginally) significant in thefull sample during the crisis. Based on our estimates, an increase in this ratio by1 percentage point increases quarterly stock returns by 11 basis points, a relativelysmall effect. The leverage ratio is not significant in the full sample. Among the largestbanks, on the other hand, the leverage ratio has a positive and strongly significantcoefficient in the crisis while the Basel ratio is insignificant. As to the magnitudeof the effect, for the large banks increasing the leverage ratio by 1 percentage pointwould have resulted in an additional 55 basis points in stock returns per quarter, or12% of the median quarterly decline of 4.7%.
1156 : MONEY, CREDIT AND BANKING
TABLE 2
STOCK MARKET PERFORMANCE AND BANK CAPITAL OVER THE FINANCIAL CYCLE
Full sample Large banks
RWR LR RWR LR(1) (2) (3) (4)
Precrisis periodCapital*PreCrisis 0.023 0.078* − 0.155 − 0.046
[0.036] [0.046] [0.102] [0.089]Liquidity*PreCrisis 0.016* 0.012 0.047** 0.041
[0.008] [0.010] [0.022] [0.026]Deposits*PreCrisis 0.013 0.017 0.013 0.014
[0.009] [0.012] [0.014] [0.013]Net Loans*PreCrisis 0.001 − 0.001 − 0.020* − 0.012
[0.007] [0.008] [0.012] [0.012]Provisions*PreCrisis − 1.204*** − 1.043** − 1.333* − 1.402
[0.374] [0.428] [0.760] [0.886]Size*PreCrisis 0.053 0.07 − 0.698 − 0.209
[0.070] [0.078] [0.839] [0.736]PB*PreCrisis 0.018*** 0.015** 0.108 0.093
[0.005] [0.006] [0.072] [0.075]PE*PreCrisis 0.000 − 0.001*** − 0.009*** − 0.009***
[0.000] [0.000] [0.003] [0.003]Beta*PreCrisis − 0.233 − 0.082 − 0.239 − 0.338
[0.242] [0.257] [0.293] [0.349]Crisis period
Capital*Crisis 0.114* 0.124 0.207 0.553***[0.063] [0.096] [0.143] [0.194](0.079) (0.597) (0.004) (0.002)
Liquidity*Crisis − 0.037** − 0.037 0.098* 0.094[0.017] [0.022] [0.056] [0.066](0.002) (0.015) (0.308) (0.334)
Deposits*Crisis 0.036** 0.038* 0.074*** 0.102***[0.016] [0.020] [0.022] [0.030](0.125) (0.180) (0.022) (0.011)
Net Loans*Crisis − 0.030* − 0.031* − 0.032 − 0.073**[0.016] [0.018] [0.028] [0.028](0.020) (0.080) (0.694) (0.043)
Provisions*Crisis − 3.014*** − 3.644*** − 2.947 − 2.927[0.995] [1.076] [2.373] [3.246](0.068) (0.017) (0.497) (0.637)
Size*Crisis − 0.038 0.043 − 1.265 − 0.73[0.088] [0.090] [0.830] [0.730](0.180) (0.691) (0.005) (0.010)
PB*Crisis 0.027 0.006 0.043 0.024[0.064] [0.062] [0.070] [0.042](0.885) (0.893) (0.582) (0.465)
PE*Crisis − 0.001*** − 0.001*** − 0.001*** − 0.001***[0.000] [0.000] [0.000] [0.000](0.267) (0.837) (0.015) (0.008)
Beta*Crisis − 0.594* − 0.754** − 0.105 0.014[0.350] [0.358] [0.506] [0.658](0.333) (0.084) (0.800) (0.585)
(Continued)
ASLI DEMIRGUC-KUNT, ENRICA DETRAGIACHE, AND OUARDA MERROUCHE : 1157
TABLE 2
CONTINUED
Full sample Large banks
RWR LR RWR LR(1) (2) (3) (4)
Country*Year FE Yes Yes Yes YesNumber of observations 4,254 3,779 887 741R2 0.23 0.23 0.31 0.32
NOTES: The estimated model is:
yi j t = ∑j t
α j t d j t + β1(dnoncrisis ∗ ki j t−1) + γ 1(dnocrisis ∗ Xi jt−1) + β2(dcrisis ∗ ki j t−1) + γ 2(dcrisis ∗ Xi jt−1) + ui j t ,
where yijt is the bank’s stock returns in quarter t; the αs, βs, and γ s are coefficients to be estimated; djt is a matrix of coun-try*time dummy variables; kijt–1 is bank capital, the variables we are mostly interested in; Xijt–1, is a matrix of bank-level control variables;dcrisis is a dummy variable for quarters during which the financial crisis was unfolding; and uijt is a disturbance term. The stock return(including dividends) is calculated as ln(RI(t)/RI(t – 1)), where RI is the Datastream total return index. The sample period for the stock returnis Q1.2006–Q1.2009. Crisis is a dummy that takes value 1 from Q3.2007–Q1.2009. Capital is measured either as total regulatory capital(Tier 1 + Tier 2) scaled by Basel risk-weighted assets (RWR) or total regulatory capital scaled by total unweighted assets (leverage ratio,LR). See Table 1 for a detailed definition of the control variables. Liquidity stands for liquid assets, deposits for total deposits (includingdemand and saving deposits), provisions for loan loss provisions, and size is the logarithm of total assets. Liquidity, deposits, net loans, andloan loss provisions are all in percentage of total assets. PB stands for market-to-book value of equity and PE for price–earnings ratio. Allexplanatory variables are lagged 1 year. We report estimates for the whole sample and the sample of large banks. Large banks are defined asbanks with total assets above $50 billion. We report standard errors clustered by bank in brackets and the p-value for the test of significantdifference between the precrisis and crisis coefficients in parentheses. *, **, and *** stand for statistically significant at the 10%, 5%, and1% levels, respectively. Robust standard errors clustered by bank are reported in brackets. In parentheses we report the p-value for the test ofequality of effects during crisis and precrisis.
The finding that the leverage ratio is significant while the regulatory ratio is notfor large banks may suggest that market participants did not view the risk adjustmentunder Basel as informative in capturing the true risk in bank portfolios during thecrisis. This also suggests that the differences in stock returns among large banks withdifferent capital levels did not just reflect expectations about actions by regulators(such as decisions to close or merge undercapitalized banks, or demand additionalcapital), as such decisions would presumably have been taken on the basis of shortfallsin regulatory capital. Rather, capital mattered because of its ability to absorb lossesas well as its possible role as a signal of bank asset quality.
When we split capital into Tier 1 and Tier 2 (Table 3), it is Tier 1 leveragethat remains significant, suggesting that market participants focused more on thecomponent of capital that is available to absorb losses while the bank continues as agoing concern. In the last four columns of Table 3, we measure capital using the ratioof tangible common equity to tangible capital. When we do this, for the full samplecapital is significant both before the crisis and during the crisis, but the coefficient issmall. For the large bank sample, the coefficient is significant and large in magnitudeduring the crisis, consistent with the results for Tier 1 leverage.
To gain a better understanding of the timing of the effects under consideration,we have estimated our empirical model separately for each quarter and plotted theestimated regression coefficients of capital and their 10% confidence interval inFigure 1. We do this exercise for the two concepts of capital (regulatory ratio andleverage ratio) and for the two samples (full sample and large banks only). The chartsshow that the “sensitivity” of stock returns to bank capital was negligible before thecrisis, and it became stronger as the crisis progressed, until the third quarter of 2008.
1158 : MONEY, CREDIT AND BANKING
TAB
LE
3
TIE
R1
AN
DT
IER
2C
API
TAL
AN
DTA
NG
IBL
EC
OM
MO
NE
QU
ITY
Full
sam
ple
Lar
geba
nks
Full
sam
ple
Lar
geba
nks
RW
RL
RR
WR
LR
RW
RL
RR
WR
LR
Full
sam
ple
Lar
geba
nks
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
(9)
(10)
Tie
r1*
PreC
risi
s0.
024
0.11
0*−
0.09
20.
061
[0.0
46]
[0.0
61]
[0.1
29]
[0.1
49]
Tie
r2*
PreC
risi
s0.
074
0.00
6−
0.10
6−
0.25
2[0
.055
][0
.072
][0
.145
][0
.178
]T
ier
1*C
risi
s0.
117
0.15
40.
264
0.60
3***
[0.0
80]
[0.1
08]
[0.1
86]
[0.2
10]
Tie
r2*
Cri
sis
0.05
10.
058
0.13
10.
415
[0.0
98]
[0.1
88]
[0.2
57]
[0.3
50]
Com
mon
equi
ty*P
reC
risi
s0.
015
0.04
8−
0.00
5−
0.00
3[0
.018
][0
.034
][0
.089
][0
.143
]O
ther
capi
tal*
PreC
risi
s−
0.09
7***
−0.
079
−0.
053
−0.
214*
[0.0
34]
[0.0
59]
[0.0
83]
[0.1
12]
Com
mon
equi
ty*C
risi
s0.
114*
*0.
165*
*0.
283*
*0.
617*
*[0
.044
][0
.067
][0
.126
][0
.278
]O
ther
capi
tal*
Cri
sis
−0.
015
0.00
20.
324*
*0.
561*
[0.0
76]
[0.1
02]
[0.1
44]
[0.2
93]
Tang
ible
equi
ty*P
reC
risi
s0.
038*
*0.
086
[0.0
19]
[0.0
77]
Tang
ible
equi
ty*C
risi
s0.
095*
**0.
532*
**[0
.031
][0
.168
]C
ontr
ols*
Cri
sis
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Con
trol
s*Pr
eCri
sis
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Cou
ntry
*Yea
rFE
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Num
ber
ofob
serv
atio
ns4,
049
3,72
682
773
63,
654
3,70
074
574
85,
495
976
R2
0.23
0.23
0.32
0.33
0.23
0.23
0.32
0.32
0.22
0.30
NO
TE
S:T
hede
pend
entv
aria
ble
isth
equ
arte
rly
stoc
kre
turn
.The
stoc
kre
turn
(inc
ludi
ngdi
vide
nds)
isca
lcul
ated
asln
(RI(
t)/R
I(t–
1)),
whe
reR
Iis
the
Dat
astr
eam
tota
lret
urn
inde
x.Se
eTa
ble
2fo
ra
deta
iled
desc
ript
ion
ofth
ees
timat
edm
odel
.The
sam
ple
peri
odfo
rth
est
ock
retu
rnis
Q1.
2006
–Q1.
2009
.All
cont
rolv
aria
bles
are
lagg
ed1
year
.Cri
sis
isa
dum
my
vari
able
that
take
sva
lue
1fr
omQ
3.20
07to
Q1.
2009
.Tie
r1
(Tie
r2)
isT
ier
1(T
ier2
)cap
itals
cale
dei
ther
byri
sk-w
eigh
ted
asse
ts(R
WR
)ort
otal
unw
eigh
ted
asse
ts(L
R).
Tie
r1ca
pita
linc
lude
ssh
areh
olde
rfun
dspl
uspe
rpet
ual,
nonc
umul
ativ
epr
efer
ence
shar
es,p
lus
reta
ined
earn
ings
.Tie
r2ca
pita
lin
clud
essu
bord
inat
edde
bt,h
ybri
dca
pita
l,lo
anlo
ssre
serv
es,a
ndva
luat
ion
rese
rves
.Tan
gibl
eco
mm
oneq
uity
issh
areh
olde
rsfu
ndm
inus
inta
ngib
leca
pita
ldi
vide
dby
tota
lta
ngib
leas
sets
.We
repo
rtes
timat
esfo
rth
ew
hole
sam
ple
and
the
sam
ple
ofla
rge
bank
s.L
arge
bank
sar
ede
fined
asba
nks
with
tota
lass
ets
abov
eU
S$50
billi
on.S
tand
ard
erro
rscl
uste
red
byba
nkar
ere
port
edin
brac
kets
and
the
p-va
lues
for
the
test
ofsi
gnifi
cant
diff
eren
cebe
twee
nth
epr
ecri
sis
and
cris
isco
effic
ient
sar
ere
port
edin
pare
nthe
ses.
*,**
,and
***
stan
dfo
rst
atis
tical
lysi
gnifi
cant
atth
e10
%,5
%,a
nd1%
leve
l,re
spec
tivel
y.R
obus
tsta
ndar
der
rors
clus
tere
dby
bank
are
repo
rted
inbr
acke
ts.
ASLI DEMIRGUC-KUNT, ENRICA DETRAGIACHE, AND OUARDA MERROUCHE : 1159-1
01
2-1
01
2
20
06
q2
20
06
q3
20
06
q4
20
07
q1
20
07
q2
20
07
q3
20
07
q4
20
08
q1
20
08
q2
20
08
q3
20
08
q4
20
06
q2
20
06
q3
20
06
q4
20
07
q1
20
07
q2
20
07
q3
20
07
q4
20
08
q1
20
08
q2
20
08
q3
20
08
q4
LR Full sample LR Large banks
RWR Full sample RWR Large banks
Graphs by Type
FIG. 1. Response of Bank Stock Returns to Lagged Bank Capital before and during the Financial Crisis.
The strongest effect is for the leverage ratio during the period Q4.2007–Q2.2008 inthe sample of large banks.
In Table 4 we estimate a slightly different version of the baseline regressions as arobustness test. Instead of carrying out the estimation for the full sample period andtwo separate samples (all banks and large banks), we estimate the model separatelyfor the precrisis and crisis periods, and interact the coefficients of the explanatoryvariables with a large-bank dummy and a small-bank dummy (with the dummyswitching value for banks with asset size above $50 billion). In an additional exercise,we run a regression for the period following the Lehman bankruptcy only, to testwhether the effect of capital on stock returns differed during the most acute phase ofthe financial crisis. The results tend to confirm our earlier findings: capital becomesmore important during the crisis, and the strongest effect is that of the Tier 1 leverageratio on stock returns of large banks. During the post-Lehman quarter, the coefficientof Tier 1 leverage for large banks is larger than in the full crisis period, suggestingthat capital was affecting stock returns particularly strongly during this period.
1160 : MONEY, CREDIT AND BANKING
TABLE 4
STOCK MARKET PERFORMANCE AND BANK LEVERAGE: SEPARATE PRECRISIS AND CRISIS REGRESSIONS
Precrisis Crisis Post-Lehman
RWR LR RWR LR RWR LR(1) (2) (3) (4) (5) (6)
Tier 1*Large − 0.034 0.088 0.165 0.536*** 0.123 0.720**[0.090] [0.093] [0.154] [0.181] [0.257] [0.323]
Tier 1*Small 0.036 0.036 0.08 0.151 0.033 0.141[0.045] [0.066] [0.114] [0.148] [0.158] [0.214]
Tier 2*Large 0.039 − 0.053 0.103 0.357 0.008 0.269[0.101] [0.158] [0.189] [0.283] [0.295] [0.388]
Tier 2*Small 0.08 − 0.052 0.049 0.161 − 0.126 0.28[0.060] [0.076] [0.130] [0.214] [0.248] [0.369]
Controls*Large Yes Yes Yes Yes Yes YesControls*Small Yes Yes Yes Yes Yes YesCountry*Year FE Yes Yes Yes Yes Yes YesNumber of observations 1,820 1,650 2,229 2,076 949 897R2 0.23 0.23 0.15 0.16 0.22 0.23
NOTES: The dependent variable is quarterly bank stock returns. The stock return (including dividends) is calculated as ln(RI(t)/RI(t – 1)),where RI is the Datastream total return index. See Table 2 for a detailed description of the estimated model. In this table report estimates forthree separate sample period: (i) the precrisis period Q1.2006–Q2.2007; (ii) the crisis period Q3.2007–Q1.2009; and (iii) the period followingLehman bankruptcy Q3.2008–Q1.2009. We also allow all coefficients to vary by bank size. Large is a dummy variable that takes value 1 ifthe bank has total assets above U.S. $50 billion and small a dummy that takes value one for all other banks. Tier 1 (Tier 2) is Tier 1 (Tier 2)capital scaled either by risk-weighted assets (RWR) or total unweighted assets (LR). Tier 1 capital includes shareholder funds plus perpetual,noncumulative preference shares, plus retained earnings. Tier 2 capital includes subordinated debt, hybrid capital, loan loss reserves, andvaluation reserves. Standard errors clustered by bank are reported in brackets. *, **, and *** stand for statistically significant at the 10%, 5%,and 1% level, respectively. Robust standard errors clustered by bank reported in brackets.
We conducted a battery of robustness checks, which we do not report for sakeof brevity.12 These tests include: an alternative definition of large banks based onoperating income; an alternative specification in which capital is measured by theleverage ratio and the ratio of risk-adjusted assets to total assets is introduced asan additional regressor; alternative estimation techniques;13 alternative measures ofliquidity; including a measure of lagged profitability (return on assets); an alterna-tive sample including countries with less than five banks (but at least two banks);alternative specifications in which we control for either market to book ratio or priceearnings ratio, but not both;14 and a specification where we include a dummy variablethat takes the value of 1 if a bank has been recapitalized with government funds in agiven quarter. Our findings are robust to all these tests.
2.2 Why Does Capital Affect Stock Returns Only among Large Banks?
These results raise the question of why the leverage ratio matters for equity pricesespecially in the sample of larger banks. One possible interpretation is that larger
12. All these results are available upon request.13. We used weighted least squares to address possible problems with the sample composition being
uneven. We also clustered standard errors by country rather than bank, by quarter, and by both countryand quarter; baseline results were not changed.
14. Fama and French (1996) showed that market to book value and price earnings ratio may containsimilar information about expected stock returns.
ASLI DEMIRGUC-KUNT, ENRICA DETRAGIACHE, AND OUARDA MERROUCHE : 1161
TABLE 5
SAMPLE SPLIT BY INITIAL CAPITAL LEVELS
High capital in 2006 Low capital in 2006
RWR LR RWR LR(1) (2) (3) (4)
Tier 1*PreCrisis − 0.006 0.111 0.294* 0.180[0.079] [0.125] [0.162] [0.126]
Tier 2*PreCrisis 0.12 − 0.044 0.177 0.061[0.105] [0.123] [0.137] [0.134]
Tier 1*Crisis 0.018 − 0.048 0.496*** 0.498**[0.108] [0.163] [0.182] [0.198](0.792) (0.126) (0.092) (0.054)
Tier 2*Crisis − 0.023 − 0.455* 0.390* 0.579*[0.187] [0.268] [0.204] [0.316](0.432) (0.129) (0.210) (0.160)
Controls*Crisis Yes Yes Yes YesControls*PreCrisis Yes Yes Yes YesCountry*Year FE Yes Yes Yes YesNumber of observations 1,857 1,795 2,192 1,931R2 0.26 0.26 0.22 0.23
NOTES: The dependent variable is the quarterly stock return. The stock return (including dividends) is calculated as ln(RI(t)/RI(t − 1)), whereRI is the Datastream total return index. See Table 2 for a detailed description of the estimated model. The sample period for the stock return isQ1.2006–Q1.2009. All control variables are lagged 1 year. Crisis is a dummy that takes value one from Q3.2007 to Q1.2009. Tier 1 (Tier 2) isTier 1 (Tier 2) capital scaled either by risk-weighted assets (RWR) or total unweighted assets (LR). Tier 1 capital includes shareholder fundsplus perpetual, noncumulative preference shares, plus retained earnings. Tier 2 capital includes subordinated debt, hybrid capital, loan lossreserves, and valuation reserves. Common equity is shareholders fund and other capital total regulatory capital minus common equity. RWRstands for risk-weighted capital ratio and LR for leverage ratio. In this table we report separate estimates for the subsamples of initially welland poorly capitalized banks. The high capital subsample includes banks with capital above the sample median in 2006, while the low capitalsample includes banks with capital below the sample median in 2006. In order to keep a reasonable number of countries in each subsample(at least 7 countries) we lower our threshold number of banks by country to 3 banks that is we obtain samples with at least 48 observationsper country (12 observations per year). Standard errors clustered by bank are reported in brackets and the p-values for the test of significantdifference between the precrisis and crisis coefficients are reported in parentheses. *, **, and *** stand for statistically significant at the 10%,5%, and 1% level, respectively. Robust standard errors clustered by bank are reported in brackets. In parentheses we report the p-values forthe test of equality of effects during crisis and precrisis.
banks with complex operations have more opportunities to take advantage of “regu-latory arbitrage” and distort the risk exposure measure used by regulators to computecapital adequacy. Also, capital’s role as a signal of a bank’s exposure to toxic assetsmay have been more important in the case of large banks, whose balance sheets aremore opaque than those of small banks.
Another interpretation is based on the Calem–Rob model. If we measure capi-talization based on “high-quality” capital such as the Tier 1 ratio or the tangiblecommon equity ratio, the larger banks in our sample were less well capitalized thanthe smaller banks, as pointed out in the previous section.15 The Calem–Rob modelpredicts that at low levels of capitalization, bank risk taking is a decreasing functionof capital, while for strongly capitalized banks the relationship has the opposite sign.If we take the size of the decline in stock prices during the crisis as a measure of themarket’s view of how much risk a bank had taken during the good times, then theCaleb–Rob model would predict a positive relationship between capital and stock
15. For instance, the median common equity ratio is 6.2% in the full sample but only 4.1% in thelarge-bank sample.
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returns for less well capitalized banks but not for better capitalized banks, which iswhat we find.
To explore this interpretation further, in Table 5 we rerun the baseline regressionssplitting the sample based on the level of capitalization at the end of 2006. Interest-ingly, for banks with capital above the median, higher capital did not translate intobetter stock performance during the crisis. On the other hand, for less well capitalizedbanks, higher capital did result in a higher stock returns during the crisis. For thissample split, we do not see a distinction between the Basel ratio and the leverage ratioor between Tier 1 and Tier 2 capital. All in all, these findings are consistent with theimplications of the Caleb–Rob model, namely, that a negative relationship betweenrisk and capital should appear only for weakly capitalized banks.
3. CONCLUSIONS
The recent global financial crisis has led to widespread calls to reform bankregulation and supervision. Changes in bank capital regulation have been at the heartof the policy discussions. In redesigning prudential standards to incorporate lessonsfrom the recent turmoil, the Basel committee of supervisors has grappled with twoimportant questions among others: What type of capital should banks hold to ensurethat they can better withstand periods of economic and financial stress? And shoulda simple leverage ratio be introduced to reduce regulatory arbitrage and improvetransparency?
We find that before the crisis, differences in initial capital—whether risk adjustedor not, however defined—did not consistently affect subsequent bank stock returns.The importance of capital, on the other hand, becomes evident during the crisisperiod, particularly for the largest banks in our sample. These are the banks of greatersystemic importance, as well as those holding lesser quality capital at the inceptionof the crisis. Our results also show that during the crisis stock returns of large bankswere more sensitive to the leverage ratio than the risk-adjusted capital ratio. Thismay be because market participants viewed the risk adjustment under Basel rulesas subject to manipulation or in any case not reflective of true risk in the case oflarge banks. Finally, we also find that the positive association with subsequent stockreturns is stronger for higher quality capital (Tier 1 leverage and tangible commonequity).
Our results have potential policy implications for the current process of regulatoryreform. First, we find support for the view that a stronger capital position is animportant asset during a systemic crisis, suggesting that the current emphasis onstrengthening capital requirements is broadly appropriate. Second, our results indicatethat the introduction of a minimum leverage ratio to supplement minimum risk-adjusted capital requirements is important, as properly measuring risk exposure isvery difficult especially for large and complex financial organizations. Finally, ourstudy indicates that greater emphasis on “higher quality capital” in the form of Tier1 capital or tangible equity is justified.
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