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Bank Capital and Uncertainty

  • Fabian Valencia

An important role for bank capital is that of a buffer against unexpected losses. As uncertainty about these losses increases, the theory predicts an increase in the optimal level of bank capital. This paper investigates this implication empirically with U.S. Commercial Banks data and finds statistically significant and robust evidence supporting it. A counterfactual experiment suggests that a decline in uncertainty to the lowest level measured in the sample generates an average reduction in bank capital ratios of slightly over 1 percentage point. However, I also find suggestive evidence that the intensity of this precautionary motive is stronger during recessions. From a policy perspective, these results suggest that the effectiveness of countercyclical capital requirements during bad times will be undermined by banks desire to hold more capital in response to increased uncertainty.

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Paper provided by International Monetary Fund in its series IMF Working Papers with number 10/208.

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Length: 22
Date of creation: 01 Sep 2010
Date of revision:
Handle: RePEc:imf:imfwpa:10/208
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  1. Fabian Valencia, 2008. "Banks' Precautionary Capital and Credit Crunches," IMF Working Papers 08/248, International Monetary Fund.
  2. Peura, Samu & Jokivuolle, Esa, 2004. "Simulation based stress tests of banks' regulatory capital adequacy," Journal of Banking & Finance, Elsevier, vol. 28(8), pages 1801-1824, August.
  3. Skander Van den Heuvel, 2006. "The Bank Capital Channel of Monetary Policy," 2006 Meeting Papers 512, Society for Economic Dynamics.
  4. John Geanakoplos & Ana Fostel, 2008. "Leverage Cycles and the Anxious Economy," American Economic Review, American Economic Association, vol. 98(4), pages 1211-44, September.
  5. Shin, Hyun Song & Adrian, Tobias, 2008. "Financial intermediaries, financial stability and monetary policy," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 287-334.
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