| Bank capital regulation was introduced for the first time in Canada in March 1983. Bank capital regulation is only desirable if it has an impact on the capital structure decisions banks make. In particular, the regulation is desirable if it causes banks to make capital structure decisions which reduce the probability of failure and its related costs.;The purpose of this thesis is to appraise the effectiveness of capital regulation by observing the capital structure decision-making behaviour of banks before and after the introduction of capital regulation. Although it may be observed that banks have increased the amount of equity in their capital structures since March 1983, it is argued by some that this increase in equity capital was a result of changes in environmental variables such as changes in risk, interest rates and corporate tax rates.;The effect of regulation is examined theoretically in this thesis. A theory of optimal capital structure for banks in the absence of capital regulation is developed. The theory developed predicts that the optimal equity/asset ratio of a bank should be positively related to the significance of bankruptcy costs and the net riskiness of the bank's asset portfolio, and negatively related to the level of interest rates and the corporate tax rate. The possible theoretical effects of regulation are then examined. Capital regulation will only have its desired impact on bank capital structures if the rules ask banks to maintain more equity capital than they would in the absence of regulation, and if banks cannot circumvent the regulation by investing in riskier assets.;The theoretical model is tested empirically using regression analysis and structural change tests. The models use both book value and market value measures of capital structure as their dependent variables, and examine what effect the existence of regulation and other environmental variables has had on observed bank capital structures.;The results indicate that the equity/asset ratios are significantly affected by the existence of capital regulation. They also appear, in varying degrees, to be affected by the level of interest rates, the corporate tax rate and the net riskiness of their asset portfolios.;The results of this thesis suggest that capital structure regulation is somewhat effective. It would be more effective, however, if it was coordinated with policies restricting the riskiness of bank assets, and a stable monetary policy. |
