Optimal Bank Capital with Costly Recapitalization

by Samu Peura of Sampo plc, and
Jussi Keppo of the University of Michigan

July 2006

Abstract: We study optimal bank capital choice as a dynamic trade-off between the opportunity cost of equity, the loss of franchise value following a regulatory minimum capital violation, and the cost of recapitalization. We introduce a recapitalization delay that results in a strictly positive probability of capital adequacy violation. We calibrate the model to bank accounting return data and evaluate the model's ability to explain observed bank capital ratios. Differences in return volatility explain a significant fraction of the cross-sectional variation in bank capital ratios. Differences in the level of capital market imperfections across banks constitute a secondary explanation.

JEL Classification: G32, G35.

Keywords: bank capital, dividends, capital issues, fixed cost, delay.

Published in: Journal of Business, Vol. 79, No. 4, (July 2006), pp. 2163-2201.

Previously titled: Optimal Capital Management with Fixed Costs and Implementation Delays

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