1 Introduction
A common justification for capital regulation for banks is the reduction of bank moral hazard.
Given the presence of deposit insurance, banks have easy access to deposit funds. If they
hold a low level of capital, there is an incentive for them to take on excessive risk. If the
risky investment pays off, the banks’ shareholders receive the payoff. On the other hand, if
it does not, the bulk of the losses are borne either by depositors or by the body providing
deposit insurance. Given the widely accepted view that equity capital is more costly for
banks than other forms of funds, the common assumption in much of the extant analyses of
bank regulation is that capital adequacy standards should be binding as banks attempt to
economize on the use of this costly input.
In practice, however, it appears that the amount of capital held by banks has varied
substantially over time in a way that is difficult to explain as a function of regulatory changes.
For example, Berger et al. (1995) report that in the 1840’s and 1850’s banks in the U.S.
had capital ratios of around 40 to 50 percent. These ratios fell dramatically throughout the
twentieth century, reaching a range of 6 to 8 percent in the 1940’s where they stayed until
the end of the 1980’s. More recent evidence in Flannery and Rangan (2004) suggests that
bank capital ratios have again increased, with banks in the U.S. now holding capital that
is 75% in excess of the regulatory minimum (see also Barth et al., 2005, for international
evidence).1 Given that capital adequacy standards were not in existence during much of the
nineteenth century, and have not fluctuated much since their inception, it is hard to find a
regulatory rationale to explain movements in banks’ capital holdings.
To better understand the role of bank capital and regulation, we present a simple model
of bank lending that incorporates two features widely believed to be important for banking
markets. First, we incorporate a consideration related to banks’ lending behavior into their
choice of financing, recognizing that banks’ capital structures may have implications for their
1A recent study by Citigroup Global Markets (2005) finds that “... most European banks have and
generate excess capital”, with Tier 1 ratios significantly above target. See also Alfon et al. (2004).