Optimal bank capital with costly recapitalization
By Samu Peura & Jussi Keppo
University of Michigan
June 2004
Abstract: We study optimal bank capital choice as a dynamic tradeoff between the opportunity cost of equity, the loss of franchise value following a regulatory minimum capital violation, and the cost of recapitalization. Our model indicates that a recapitalization option may be valuable despite substantial delays and costs of capital issuance, and that a significant fraction of the value of low capitalized banks may be attributable to the option to recapitalize. We calibrate the model to bank accounting return data and evaluate the model’s ability to explain observed bank capital ratios. We find that the model has the potential to replicate a significant amount of the cross-sectional variation in bank capital ratios by relating these to differences in return volatility. Differences in the level of capital market imperfections across banks constitute a secondary explanation. Our analysis points to the need for improved forward looking estimates of bank return volatility.
