The changing face of bank capital structure, 1986--1998: Regulators vs. markets

Equity ratios in the banking industry have dramatically increased over the last decade and a half and are currently at the highest levels witnessed over the last seventy years. This study investigates the reasons behind this dramatic change in bank capital structure.; In this study, I show that over the sample period (1986–98) the banking industry has moved from a regulatory regime, wherein equity ratios of a large number of banks were constrained by capital standards, to a market regime wherein few banks seem to be constrained by capital regulation. Hence, contrary to popular belief, the introduction of the Basle standards had little effect on changes in bank equity ratios.; To investigate the reasons behind the observed increases in equity ratios, I develop a theoretical model that highlights the determinants of the optimal equity ratio for a value-maximizing bank in a market regime. Using the framework of this model, I derive both, theoretical propositions as well as empirically testable hypotheses that can explain the phenomenon under study.; The empirical analysis in this study tests the proposed hypotheses on a sample of banks that on average held over 75% of all banking assets. The sample period extends from 1986 through 1998. The results show that the change in regulatory stance on bank bailouts increased the sensitivity of risk on equity ratios, thereby increasing the amount of equity banks held, per unit risk. The results also provide support to the hypothesis that the investment opportunity set available to banks changed over the sample period. After controlling for other effects, it seems that this change in the investment opportunity set increased asset risk and thus increased equity ratios of banks. These two hypotheses (change in regulatory stance and change in investment opportunity set) together account for close to 60% of the observed changes in equity ratios.