How Have Banks Managed Their Capital – A Ratio Decomposition Analysis

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How Have Banks Managed Their Capital – A Ratio Decomposition Analysis Abstract This paper is motivated by the conflicting evidence in prior bank capital structure literature and the lack of resilience of bank capital to the current financial crisis of 2007-2010. The paper analyzes the reaction of banks’ asset portfolio and capital structure to adverse changes of regulatory capital ratios. Based on management discretionary decisions pertaining to balance sheet items, I question whether banks respond to declines in tier 1 and total regulatory capital ratio through gaming the leverage ratio or though the risk-weighted assets. The paper employs a ratio decomposition approach, where the regulatory ratio is broken down to its components of leverage along with detailed positions in various risk-weighted asset classes. I also examine whether asset risk weighting is effective in measuring the degree of bank riskiness. Therefore, I test whether response of bank managers to declines in regulatory capital changes through risk-weighted assets is associated with other measures of risk. Finally, I conjecture that managers use discretion to manage regulatory capital through changes of asset positions and classification to relevant risk classes. 1. Background and Motivation Looking at the contradictory results of prior research on bank capital structure, banks seem to face conflicting goals emanating from shareholders, debt holders and regulators (Gropp and Heider, 2009). Shareholders aim at maximizing the return on the equity invested. Therefore, they implicitly get along with as small equity capital as feasible to achieve their objective. Debt holders have different goals to minimize the riskiness of assets as opposed to raising new e... ... middle of paper ... ...erican Economic Review, 48 (3), 261-297. Moyer, S. (1990) “Capital Adequacy Ratio Regulations and Accounting Choices in Commercial Banks”, Journal of Accounting and Economics, 13 (2), 123-154. Myers, and Majluf, (1984) “Corporate Financing and Investment Decisions When Firms Have Information That Investors Donot Have”, Journal of Financial Economics, 13(2), 187-221. Schrand, C. and Wong, M. (2003) “Earnings Management Using the Valuation Allowance for Deferred Tax Assets under SFAS No. 109” Contemporary Accounting Research, 20 (3), 579-611. Wall, L. and Peterson, D. (1987) “The Effect of Capital Adequacy Guidelines on Large Bank Holding Companies” Journal of Banking & Finance, 11 (4), 581-600. ______ and __________ (1995) “Bank Holding Company Capital Targets in the Early 1990s: The Regulators Versus the Markets” Journal of Banking & Finance, 19 (3-4), 563-574.
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