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The Capital Conundrum

Author

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  • Richard J. Herring

    (The Wharton School, University of Pennsylvania)

Abstract

After a review of the theory of regulation of bank capital, this paper notes that the pervasive influence of the safety net provides both a rationale for regulating bank equity capital and an obstacle to inferring what the optimal capital-to-asset ratio would be for a bank in the absence of the safety net (or expectations of an ex post bailout). This paper supports the view that the cost of bank equity capital is less than is frequently assumed, but notes that many of the frictions that lead to optimal equity-to-asset ratios for other firms are likely to apply to banks. Moreover, the analysis of bank capital structures is further complicated by the fact that a significant proportion of bank liabilities—deposits—are an important product offered by banks as well as a means of increasing leverage. After a brief overview of the potential advantages of a requirement for contingent convertible capital (CoCo) instruments in addition to higher equity-to-asset ratios, the paper argues that, given the uncertainty about the optimum equity capital requirement, a substantial CoCo requirement provides additional advantages, which include stronger incentives for banks to recapitalize before they encounter serious difficulties, enhanced incentives for banks to adopt the best possible risk-management measures, and (so long as the regrettable asymmetry between interest and dividends remains) reduced incentives for banks to move activities to the shadow banking system. A substantial CoCo requirement protects society from loss as effectively as an equivalent amount of additional equity capital, but CoCos enable a bank to recapitalize automatically if it falls short of the equity capital requirement. This recapitalization will occur instantaneously and at lower cost than a new issue of equity under conditions of stress. Instantaneous recapitalization will give the bank an opportunity to restructure or find a private solution and will provide the regulatory authorities with sufficient warning to prepare a rapid resolution if necessary.

Suggested Citation

  • Richard J. Herring, 2011. "The Capital Conundrum," International Journal of Central Banking, International Journal of Central Banking, vol. 7(4), pages 171-187, December.
  • Handle: RePEc:ijc:ijcjou:y:2011:q:4:a:7
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    References listed on IDEAS

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    1. David Miles & Jing Yang & Gilberto Marcheggiano, 2013. "Optimal Bank Capital," Economic Journal, Royal Economic Society, vol. 123(567), pages 1-37, March.
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    Cited by:

    1. repec:eee:accfor:v:39:y:2015:i:1:p:1-18 is not listed on IDEAS
    2. repec:ces:ifodic:v:11:y:2014:i:4:p:19105947 is not listed on IDEAS
    3. Murphy, Gareth & Walsh, Mark & Willison, Matthew, 2012. "Financial Stability Paper No 16: Precautionary contingent capital," Bank of England Financial Stability Papers 16, Bank of England.
    4. Naďa Blahová, 2015. "Analysis of the Relation between Macroprudential and Microprudential Policy," European Financial and Accounting Journal, University of Economics, Prague, vol. 2015(1).
    5. Kotz, Hans-Helmut & Schmidt, Reinhard H., 2017. "Corporate governance of banks: A German alternative to the "standard model"," SAFE White Paper Series 45, Goethe University Frankfurt, Research Center SAFE - Sustainable Architecture for Finance in Europe.
    6. Florian Buck, 2014. "Financial Regulation and the Grabbing Hand," ifo DICE Report, ifo Institute - Leibniz Institute for Economic Research at the University of Munich, vol. 11(4), pages 03-13, 01.

    More about this item

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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