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Abstract

Motivated by massive bank failures during the financial crisis, this paper examines whether capital adequacy ratios required by regulators are associated with bank failure. It investigates whether the association is affected by the bank's proximity to the minimum required capital ratios. If results show a significant association between regulatory capital and failure of banks falling below the minimum capital ratios, then the ratios are set at an adequate level. Examining a sample of 560 US bank holding companies for the period 2003–2009, results reveal that the association between the core (Tier 1) capital ratio and bank failure becomes significant only if the bank holding company has a Tier 1 capital ratio of less than 6%. This is the level below which US bank regulators do not regard banks as being well capitalized. During the financial crisis period of 2007–2009, there is a significant association only when the criterion is set at or above 8%. Market-based probability of default is more significantly associated with failure relative to Tier 1 capital ratio. The findings of this paper are relevant to regulatory policy discussions and Basel III deliberations on capital adequacy at times of financial turmoil.

7. Conclusion

One of the aims of banking regulation is to preclude bank failure. This is due to the importance of the banking system resilience in sustaining economic growth. This paper examines whether the minimum capital ratios required by bank regulators are associated with bank distress. More specifically, we investigate the association between the regulatory Tier 1 capital ratio and US bank holding company distress during 2003–2009. The results show that Tier 1 capital ratio is insignificantly negatively associated with bank distress. However, the association is significant when bank holding companies fall below the wellcapitalization ratio of 6%. In a subsidiary test, findings show that although the components of the Tier 1 capital ratio signifying equity adjustments, leverage and risk are insignificantly associated with bank distress, the association is significant when banks hit the 6% ratio. Further tests show that the Tier 1 capital ratio is insignificant in association with distress if the bank holding company is well capitalized. The regulatory capital is associated with bank distress only when banks have below 6% Tier 1 capital ratio i.e. without hitting the critical threshold, below which they are placed into receivership/conservatorship. This result is expected as regulatory-capital-constrained banks are faced with significant direct and indirect sanctions if they do not meet regulatory minimum requirements. On the other hand, well-capitalized banks may face lower pressure to mitigate distress even upon a signifi- cant reduction in their Tier 1 capital ratios. Additionally, the association between regulatory capital ratios and bank distress differs in the period of the financial crisis of 2007–2009.