What capital does for banks

Visiting Prof. BouwmanProf. Christa Bouwman

Capital helps all weather a banking crisis, but at other times the benefit to large banks is relatively small, MIT researcher finds

CAMBRIDGE, Mass., Oct. 26, 2009 — In a financial crisis, does having more capital help a bank survive? Will extra capital help a bank prosper in normal times? In a stock market crisis, will banks with more capital perform better?

To answer these and related questions, MIT Sloan School Visiting Professor Christa Bouwman and Allen Berger of the University of South Carolina analyzed a quarter century of US bank performance data. They tracked the capital positions of over 18,000 US banks from 1984 to the end of 2008, then used statistical analysis to determine how capital affected banks' profitability, market share, and ability to survive.

Their conclusion: Capital helps all banks survive and perhaps even prosper in a banking crisis. But in normal times or in a stock market crisis, whether more capital helps a bank depends on the bank’s size.

Small or community banks benefit from having higher capital ratios under any conditions. But for large banks, having more capital does not provide a competitive advantage in normal times or in a stock market crisis, the researchers found.

"We find very consistent results," says Bouwman. "For small banks, if you have more capital, you seem to be able to improve your market share during banking crises as well as stock market crises. For large banks, however, more capital improves their market shares only during a banking crisis.”

The survival probability results are also striking. "During banking crises, having more capital greatly improves banks' ability to survive," Bouwman says. "During stock market crises, the survival probability is generally higher and depends far less on capital."

The research is timely. How much capital banks should hold is an important question for both bankers and government regulators. In the aftermath of the worst banking crisis since the 1930s, policymakers need to know if requiring banks to hold more capital is a way to avoid such calamities in the future.

To reach their findings, Bouwman and Berger analyzed data for banks over a period that included two major banking crises—the credit crunch of the early 1990s and the crisis that began in late 2007—and three market crises—the 1987 Wall Street crash, the Russian debt crisis of 1998, and the bursting of the dot-com bubble and the September 11 terrorist attacks.

The researchers also examined bank capital and bank performance in times when there were no crises.

Capital helps all banks in a banking crisis, according to Bouwman. "During a banking crisis, losses on loans and securities may quickly wipe out the capital cushion of banks with less capital, forcing them into failure or acquisition by a stronger institution. People may start withdrawing deposits if they are afraid a bank won't survive. This elevates the banks’ risk, so more capital helps them survive," she says.

For small banks, more capital helps at all times, according to Bouwman. Unlike large banks, small banks are vulnerable to failure even during normal times, especially because they do not have “too-big-to-fail” regulatory protection and because they may find it more difficult than large banks to raise capital in a pinch. Small banks are typically not publicly traded and hence can’t raise capital from equity markets. To compete with their larger brethren, small institutions need healthy balance sheets with ample capital.

For large banks in normal times, raising capital is less difficult than for small banks, so having a large amount of capital is not a significant competitive advantage, according to Bouwman. "And holding more capital is more expensive than financing your activities with more deposits or other sources of financing," she notes.

But during a crisis of the banking sector, capital also becomes vital to large banks, Bouwman says. Not only does extra capital help a bank survive bad loans and depositor runs on the bank, it also allows them to buy weaker banks.

"The stronger banks in a banking crisis are the ones that have more capital," Bouwman says. "By acquiring weaker banks, they're gaining market share."

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