Capital regulations and commercial banks’ optimal capital structure

Farina Ria Nordam & Vedran Kontic

Student thesis: Master thesis


Capital Regulation has long been discussed among regulators, experts, scholars and financial practitioners. History proves that even Adam Smith who is considered, as the father of ¡°free market economy¡± believed some regulation of banking practices was justified (1776). History further signifies that one of the main issues in the bank sector to deal with has been the following: ¡°how much and what kind of bank regulation is optimal?¡± Consequently, the bank sector has gone through a long history of continuous regulations and deregulations. The capital regulation proposed by Bank for International Settlement (BIS) to maintain enough capital to absorb losses without causing systemic problems and to create an equal playing field internationally has also gone through some major changes since its initiation in the early 1990s. Dealing with a more developed and complex financial system, Basel Accords have gone through some improvements to find the ¡°optimal capital regulation ratio¡±. Risk Weighted Assets (RWA) of Basel II, for example, has been claimed to be one of the sources of recent financial crisis. As a result reacting the recent solvent and liquidity crisis, BIS advocates Basel Accord III. The new proposal, that is meant to strengthen the resilience of the banking sector and to avoid another crisis in the future, recommends a common equity ratio from 2% to 7%. (Including capital conservation buffer). The higher common equity ratio is proposed due to the incapability of the earlier tier 1 capital in absorbing losses. Based on the recent proposal of the BIS concerning the higher common equity usage in the bank.s capital structure, we then develop our master thesis. In answering our main research question: ¡°to investigate the implementation of higher capital requirement on the commercial banks optimal capital structure and risk taking¡± we posted four sub questions to lead us in answering the main research question. We investigate the impact of higher capital requirement in the commercial banks by applying modern corporate finance optimal capital structure theories (i.e. Modigliani & Miller Theorem, trade-off and pecking-order theory). Furthermore we also examine the impact of higher capital requirement on the banks risk taking. It is due to the fact that BIS.s Regulatory Capital Ratio is predisposed to balance the capital hold and risk-taking by a bank. In discussing this part we illustrate the development of Basel Accords´ Asset Risk-Weight and VaR risk measurement methods. Understanding the complication of the banks´ risk management we then investigate how the increase of capital ratio has influenced the US Commercial Banks´ risk-taking.

EducationsMSc in Applied Economics and Finance, (Graduate Programme) Final Thesis
Publication date2011
Number of pages147