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Why do banks hold capital in excess of regulatory requirements? A functional approach

Diemo Dietrich and Uwe Vollmer

No 192, IWH Discussion Papers from Halle Institute for Economic Research (IWH)

Abstract: This paper provides an explanation for the observation that banks hold on average a capital ratio in excess of regulatory requirements. We use a functional approach to banking based on Diamond and Rajan (2001) to demonstrate that banks can use capital ratios as a strategic tool for renegotiating loans with borrowers. As capital ratios affect the ability of banks to collect loans in a nonmonotonic way, a bank may be forced to exceed capital requirements. Moreover, high capital ratios may also constrain the amount a banker can borrow from investors. Consequently, the size of the banking sector may shrink.

Keywords: incomplete contracts; minimum capital requirements; bank capital; disintermediation; pro-cyclicality (search for similar items in EconPapers)
JEL-codes: G21 G28 (search for similar items in EconPapers)
Date: 2004
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