Estimation error in regulatory capital requirements: theoretical implications for consumer bank profitability

Abstract

Despite the topic's societal importance and despite progress in bank research, a lack of consensus exists concerning either the desirability of bank regulation or its optimal design. Enforcement of minimum bank capital standards has been shown to enhance bank stability, but also serves as a potential source of incremental costs, some of which are subtle. Such widely ambiguous research results point to the need for theoretical research regarding capital regulation across diverse banking systems. Along the latter lines, consumer bank issues have been generally neglected. This paper theoretically examines the performance implications of misestimating the regulatory capital requirement for a stylised consumer bank. For our stylised consumer bank, we prove that misestimation, irrespective of its direction, results in lower economic profits and, hence, value. Conclusions and implications for future work are drawn.

Keywords:

• Basel II
• economic capital
• consumer credit

Acknowledgements

A number of the ideas presented here were first considered in a paper given at the conference Credit Scoring and Credit Control IX (Beling et al, 2005b). The authors acknowledge the substantial contributions to that work made by Wei Jiang, who was at that time a student at the University of Virginia.

The authors are also grateful to the anonymous reviewers, who provided many helpful comments and suggestions for improvement.

Notes

1 For banks, capital refers specifically to equity whereas to non-depository firms, capital includes all funding sources, that is debt, equity, and quasi-equity. Capital requirement, in this paper, refers to equity requirement.