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Banking and optimal capital ratio in an equilibrium model

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  • Bo Larsson

Abstract

The author address the question of optimal capital ratio in banking, particularly the fact that banks' risk-weighted capital is substantially larger than the stipulated reserve requirements by the Bank of International Settlements. With a factor model for the value of entrepreneurs' projects and costly state verification as asymmetric information structure, the author shows that banks choose to hold capital reserves that are almost large enough to eliminate the risk for their depositors. The reason is that the cost of lowering the risk for the bank, up to a point, is lower than their gain from cheaper deposits. Banking risk stems from borrowers being correlated. This has been an important lesson during the ongoing financial crisis where several banks underestimated the correlation in their loan portfolios and suffered severe credit losses. This could also explain why small regional banks in Sweden often have more than twice the capital ratio of their nationwide competitors.

Suggested Citation

  • Bo Larsson, 2010. "Banking and optimal capital ratio in an equilibrium model," International Journal of Banking, Accounting and Finance, Inderscience Enterprises Ltd, vol. 2(4), pages 309-331.
  • Handle: RePEc:ids:injbaf:v:2:y:2010:i:4:p:309-331
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    References listed on IDEAS

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    Cited by:

    1. Larsson, Bo & Wijkander, Hans, 2015. "Dynamic Banking with Endogenous Risk Based Funding Cost: Value Maximization, Risk-taking, Responses to Regulation and Credit Contraction," Research Papers in Economics 2015:3, Stockholm University, Department of Economics.

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