Date of Award

1984

Document Type

Dissertation

Degree Name

Doctor of Philosophy (PhD)

Abstract

The recent failures of large banks coupled with unstable economic conditions have generated a renewed interest in the regulation of large commercial banks. In particular, the regulation of bank capital by federal banking authorities, which for years, has assumed the role as protector of overall banking soundness, has become a highly debated topic. This issue is by no means indigenous to recent times and the academic and professional literature is replete with studies attempting to solve the capital adequacy dilemma. Exactly how much capital is enough to ensure the soundness of the banking industry has not been agreed upon. But, in a ceteris paribus environment, the addition of equity to a bank's balance sheet is generally regarded as necessary in order to reduce a bank's probability of default. This study recognizes the normative aspect of capital regulation but suggests that a bank may take actions to thwart the regulator. Specifically, in response to a regulated increase in capital, it is possible (probable) that a bank will alter its investment decision, reshuffle its asset portfolio by investing in riskier assets, and thereby increase its probability of default. Such actions would surely retard the effects of the regulators. In order to test the asset portfolio reshuffling hypothesis and default risk hypothesis, a sample of 79 banks which were forced by regulators to increase capital from 1973-1980 were identified. Using matched-pair procedures, the behavior of the banks was analyzed with univariate and multivariate statistical techniques. Differences in behavior were accounted for by comparing various income statement and balance sheet data items representing asset portfolio composition and risk-return proxies. The empirical results confirm that banks do respond to capital regulation by reshuffling their asset portfolios. Banks forced to raise capital levels invested in more riskier assets than expected and became more operationally efficient than the banks not required to increase equity capital. And, as a result of this improved efficiency, the observed asset portfolio reshuffling did not result in an increase in the sample bank's probability of default.

Pages

166

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