Abstract
U.S. banks hold significantly more equity capital than required by their regulators. We test competing hypotheses regarding the reasons for this “excess” capital, using an innovative partial adjustment approach that allows estimated BHC-specific capital targets and adjustment speeds to vary with firm-specific characteristics. We apply the model to annual panel data for publicly traded U.S. bank holding companies (BHCs) from 1992 through 2006, an extended period of increasing bank capital that ended just before the subprime credit crisis of 2007–2008. The evidence suggests that BHCs actively managed their capital ratios (as opposed to passively allowing capital to build up via retained earnings), set target capital levels substantially above well-capitalized regulatory minima, and (especially poorly capitalized BHCs) made rapid adjustments toward their targets.
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Notes
The complete rules for determining a BHC’s capital adequacy are provided in Appendix A to CFR Part 225 (Regulation Y).
We evaluate book-valued capital ratios because supervisory minima apply to book values. It remains an open question whether a firm, left to its own devices, would evaluate its leverage in terms of book or market values.
Gropp and Heider (2007) conclude that minimum supervisory standards are largely irrelevant for large U.S. and European banking firms, at least under normal industry conditions. Although we evaluate a very similar question, our analysis differs in several important regards from Gropp and Heider (2007). First, Gropp and Heider investigate the determinants of book-valued and market-valued equity ratios, while we explicitly study the regulatory capital ratios. Second, their static regression imposes the assumption that capital is chosen each period without regard to the prior year’s capital. This assumption is not consistent with significant leverage adjustment costs. Finally, our explanatory variables reflect banking institutional arrangements more closely than Gropp and Heider’s, who utilize the same balance ratios typically related to nonfinancial firms’ leverage ratios.
In “pooling of assets” mergers, the acquired firm’s assets remained valued at their book values; as a result, no additional capital needed to be raised to complete the merger. In contrast, the post-2001 “purchase” method of accounting recognizes capital gains in the target’s assets, which increases the amount of equity required for the post-merger entity. We estimated several versions of our empirical analysis below that included an interaction term between our merger strategy variable and a post-June 2001 dummy; the coefficient on this interaction variable was never statistically significant and hence we dropped the variable from the specifications shown here.
Berger and Bouwman (2008) suggest that large banks might choose high capital ratios in order to gain advantages during banking crises. The authors find that high-capital banks gained market share (in terms of liquidity creation), improved their profitability, and enjoyed higher abnormal stock market returns relative to low-capital banks during both the credit crunch of the early 1990s and the recent subprime lending crisis.
This procedure ignores any acquisitions of BHCs that are not already included in our data set of large, publicly traded BHCs. Such omissions are likely to be relatively small.
The distortion in 1999 may be related to the unusual amount of bank acquisition activity in 1998. Approximately $200 billion (market value of equity) worth of banks were acquired in the U.S. during 1998, including the NationsBank-Bank of America, Wells Fargo-Norwest, and Bank One-First Chicago NBD deals. Absorbing these large acquisitions apparently sidelined large acquisitive banks for a year, resulting in only about $60 billion worth of bank merger deals in 1999. (Data from Thomson Financial.)
On January 1, 2005, the U.S. supervisory rating system for bank holding companies changed from a “BOPEC” system to an “RFI(C)” system. The new rating system emphasizes risk management (R), financial condition including capital adequacy, asset quality, earnings, and liquidity (F), impact of the parent company and nondepository entities on the subsidiary depository institutions (I), and a composite rating (C). R is rated on a three-point scale of Strong, Adequate, or Weak, while F, I, and C are rated on a 1 to 5 numeric scale as in the past, with a 1 indicating the highest rating.” For the final two years of our sample, the composite C rating from RFI(C) is used in place of the composite BOPEC rating to form the variable BADBOPEC (described below).
The exact thresholds between these categories are not crucial for our analysis; we experimented in our regressions with alternative ranges for these capital adequacy dummies, and found robust results.
Strictly speaking, Eq. 3 does not include a lagged dependent variable since DNK i,t is not identical to k i,t−1. However, the lagged capital ratio is a prominent component of DNK. The correlations between DNK i,t and k i,t−1 are 0.78, 0.86, and 0.81, respectively, for CAPLEV, CAPTEIR1, and CAPTOTAL.
The calculation is −0.2120 + 0.0119 × 16.87 = −0.0112, where 16.87 is the natural log of the mean of ASSETS for BHCs with assets greater than $50 billion.
The first calculation is −0.0097 × (1/$4.1) × $10 = −0.0237, where the mean of ASSETS (note: not LNASSETS) is $4.1 billion. The second calculation is (−0.0097 + 0.0119) × (1/$213.2) × $10 = 0.0001, where the mean of ASSETS is $213.2 billion.
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The authors thank Doug Evanoff and the Federal Reserve Bank of Chicago for inviting the presentation; Phil Strahan and an anonymous referee for insightful comments on an earlier draft; seminar participants at Fordham University, Cornell University, the University of Kansas, and Renssalaer Polytechnic Institute for helpful comments; and Norah Barger, John Connolly, Beth Klee, and Kevin Wilson for very helpful background material.
The opinions expressed do not necessarily reflect those of the Federal Deposit Insurance Corporation (David Lee).
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Berger, A.N., DeYoung, R., Flannery, M.J. et al. How Do Large Banking Organizations Manage Their Capital Ratios?. J Finan Serv Res 34, 123–149 (2008). https://doi.org/10.1007/s10693-008-0044-5
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DOI: https://doi.org/10.1007/s10693-008-0044-5