How Does Capital Affect Bank Performance during Financial Crises?

The recent financial crisis has raised important issues regarding bank capital. Various reform proposals involve requiring banks to hold more capital. But assessing these proposals requires an understanding of how capital affects bank performance. Existing theories produce conflicting predictions regarding the effect of capital on bank performance during normal times and have little to say about the effect during financial crises. This paper addresses these issues empirically by formulating and testing hypotheses regarding the effect of capital on three dimensions of bank performance - survival, market share, and profitability - during financial crises and normal times. We distinguish between two banking crises and three market crises that occurred in the U.S. over the past quarter century. We have two main results. First, capital helps banks of all sizes during banking crises. Higher capital helps these banks increase their probability of survival, market share, and profitability during such crises. Second, higher capital improves the performance of small banks in all three dimensions during market crises and normal times as well, but the effect on medium and large banks during these periods is less pronounced. Overall, our results suggest that capital is important for small banks at all times and is important for medium and large banks primarily during banking crises.