Ex Ante Capital Position, Changes in the Different Components of Regulatory Capital and Bank Risk

We investigate the impact of changes in capital of European banks on their risk- taking behavior from 1992 to 2006, a time period covering the Basel I capital requirements. We specifically focus on the initial level and type of regulatory capital banks hold. First, we assume that risk changes depend on banks' ex ante regulatory capital position. Second, we consider the impact of an increase in each component of regulatory capital on banks' risk changes. We find that, for highly capitalized and strongly undercapitalized banks, an increase in equity positively affects risk; but an increase in subordinated debt has the opposite effect namely for undercapitalized banks. Moderately undercapitalized banks tend to invest in less risky assets when their equity ratio increases but not when they improve their capital position by extending hybrid capital. Hybrid capital and equity have the same impact for banks with low capital buffers. On the whole, our conclusions support the need to implement more explicit thresholds to classify European banks according to their capital ratios but also to clearly distinguish pure equity from hybrid and subordinated instruments.