Title: Banking and optimal capital ratio in an equilibrium model

Authors: Bo Larsson

Addresses: Department of Economics, School of Technology and Business Studies, Dalarna University, 781 88 Borlange, Sweden

Abstract: The author address the question of optimal capital ratio in banking, particularly the fact that banks| risk-weighted capital is substantially larger than the stipulated reserve requirements by the Bank of International Settlements. With a factor model for the value of entrepreneurs| projects and costly state verification as asymmetric information structure, the author shows that banks choose to hold capital reserves that are almost large enough to eliminate the risk for their depositors. The reason is that the cost of lowering the risk for the bank, up to a point, is lower than their gain from cheaper deposits. Banking risk stems from borrowers being correlated. This has been an important lesson during the ongoing financial crisis where several banks underestimated the correlation in their loan portfolios and suffered severe credit losses. This could also explain why small regional banks in Sweden often have more than twice the capital ratio of their nationwide competitors.

Keywords: banking risk; costly state verification; CSV; credit risk; correlated borrowers; capital ratio; equilibrium modelling; capital reserves; small regional banks; national banks; Sweden.

DOI: 10.1504/IJBAAF.2010.037153

International Journal of Banking, Accounting and Finance, 2010 Vol.2 No.4, pp.309 - 331

Published online: 29 Nov 2010 *

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