Banks' Equity Capital Frictions, Capital Ratios, and Interest Rates: Evidence from Spanish Banks

Banks’ choices on their economic capital factor into the cost of funds and are key to the assessment of the social cost from higher equity capital ratios set by Basel III. We model the determinants of equity capital and the influence of its ratios on the interest rates of bank loans by using data from Spanish banks. The results show that a combination of valuemaximization choices and inertial earnings retentions determine equity capital and that the inertia component is more important to savings banks than to commercial banks. We also find that loans’ interest rates increase with equity capital and the increase is higher during the adjustment period than in the steady state.