On the banking capital in Europe and its relationship with risk and efficiency.

This thesis examines the capital, risk and efficiency relationship in European banking in the 1990s. The topic is particularly relevant in the European context, as the ongoing process of increased financial integration is enhancing competition and emphasising the importance of efficiency. Yet, these factors could also increase incentives for bank risk-taking. In this environment, bank capital has become a focal point of bank regulation as the primary means for limiting risk taking by banks. The empirical analysis conducted builds on the earlier US work by Kwan and Eisenbeis (1997) and Berger and De Young (1997). We developed the aforementioned approaches by including market measures of bank risk, as well as including proxies accounting for charter value, and profit efficiency in a model evaluating the determinants of European bank capital. A positive effect of inefficiency on bank risk-taking, and also of inefficiency on higher leverage were found, supporting the moral hazard hypothesis. The latter implies that inefficient banks are more likely to have more incentives towards risk taking. In addition, excessive rates of loan growth are found to have a negative effect on banking risk and efficiency. This supports the hypothesis that due to agency problems entrenched managers may pursue a growth objective, which may damage both the risk and efficiency position of the institution. The empirical model results show a positive effect of risk on capital probably indicating regulators' preference for capital, as a means of restricting risktaking activities. Finally, as in most studies analysing the determinants of bank efficiency, capital is found to affect positively the efficiency of banks. The empirical results of this research concord with earlier US work by Kwan and Eisenbeis (1997) and Berger and De Young (1997). Overall, the results presented in this thesis suggest that moral hazard incentives may be playing an important role increasing systematic risk in European banking