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Capital regulation in the form of minimum capital requirements is the most popular instrument in current banking regulation. The prevalence of minimum capital requirements is the result of a process of deregulation starting in the 1970s. In the course of deregulation, regulators have subsequently abolished, among other instruments, limitations on eligible banking activities and deposit rate ceilings. In order to limit the probability of default, they continued to require banks to hold a certain amount of capital measured as a percentage of total assets. The rationale was that capital acts as a buffer: As bank owners’ claims are subordinate to depositors’ claims, banks are solvent if their asset value is at least as high as depositors’ claims. In order to guarantee that funds are still available to pay back depositors and other creditors of a bank in the case of financial distress, minimum capital requirements introduce a higher artificial insolvency threshold. In the Savings and Loan Crisis in the US and in the Latin-American crisis, it became, however, apparent that minimum capital requirements that do not depend on banks’ asset risk are not sufficient to limit the probability of default. Hence, regulators tried to bind minimum capital requirements to banks’ asset risk by measuring capital as a percentage of risk-weighted assets.

If financial markets are assumed to be complete and depositors are perfectly informed about the failure risk of banks, the Modigliani and Miller (1958) indeterminacy principle applies. This, however, requires that owners do not have the possibility to exploit depositors. To illustrate this problem, let us assume that bank managers act in the interest of owners, who seek to maximize the value of equity. If the bank is a corporation (as most banks are), the bank owners’ liabilities are limited to the amount of their investments. This means that the owners’ losses are limited, but their gains are not: Once, the value of the bank is greater than the fixed amount owed to depositors, gains fully fall to owners. Due to this convex payoff function of owners, banks prefer risky to save investments.

Since the process of deregulation of banks in the 1970s, the supervision of banks has relied mainly on minimum capital requirements. This prominent role of minimum capital requirements is particularly reflected in the Basel Capital Accord of 1988 and the current process of its revision (Basel II). However, the importance attached to capital requirements in the supervision of banks raises several questions: How do banks react to capital requirements? Do they increase capital when their capital ratio approaches the regulatory minimum? Do they also adjust risk and how are these adjustments interrelated? And finally, Do minimum capital requirements also have an effect on well-capitalized banks?

The role of banks in transmitting monetary shocks and the effect of banks’ capitalization in this transmission process have been discussed extensively in the literature (e.g., Kishan and Opiela 2000; Van den Heuvel 2003). In contrast, their role in transmitting GDP shocks has received only minor attention, although poorly capitalized banks have the potential to amplify business cycles. Poorly capitalized banks facing materializing credit risk in a business cycle downturn have basically two options to avert falling below the minimum capital requirement. First, they could raise capital. However, this may be hard in a downturn, as extermal capital sources are scarce and expensive, while retaining earnings may not be an option due to low returns. And second, banks can increase their capital buffer by reducing risk-weighted assets. However, bank-specific assets are often not marketable and/or prices are depressed during a business cycle downturn to an extent that a sale implies prohibitive losses. Consequently, a decrease in risk-weighted assets occurs through a cut in lending. If this cut in lending is stronger than indicated by decreasing loan demand, the business cycle downturn is further amplified.

The workhorse of the traditional banking literature is the model of moral hazard: As deposit rates are irresponsive to the risk-taking of banks due to the existence of deposit insurance, banks have an incentive to decrease capital-to-asset ratios and to increase asset risk, thereby increasing their probability of default and extracting wealth from the deposit insurance system.

The fact that the Basel Committee on Banking Supervision has been working on formulating the new capital standards called Basel II since 1999 (including four past quantitative impact studies (QIS) and a fifth upcoming one) clearly shows how much emphasis today’s banking regulators put on minimum capital requirements. This study aims at contributing to the understanding of how banks behave in the light of capital requirements. In particular, the three empirical chapters of this study analyze the following three questions. How do banks adjust capital and asset risk after an increase in capital requirements (Chapter 3)? How do banks adjust their regulatory capital buffer over the business cycle (Chapter 4)? And, What is the impact of banks’ charter value on the regulatory capital buffer (Chapter 5)?