A Theory of Precautionary Regulatory Capital in Banking

The orthodox assumption in the banking literature is that capital requirements are a binding constraint on banking behaviour. This is in conict with the empir-ical observation that banks hold a bu¤er of capital well in excess of the minimum requirements. This paper develops a model where capital is endogenously deter-mined within a pro\u85t maximising equilibrium. Optimality involves balancing the reduction in expected costs associated with regulatory breach with the excess cost of nancing from increasing capital. We demonstrate that when the equilibrium probability of regulatory breach is less than one half, banks are expected to hold precautionary capital. Key words: endogenous capital, precautionary capital, capital requirements, bankin