A Theory of Precautionary Regulatory Capital in Banking

The orthodox assumption in the banking literature is that capital requirements are a binding constraint on banking behaviour. This is in conflict with the empirical observation that banks hold a bu¤er of capital well in excess of the minimum requirements. This paper develops a model where capital is endogenously determined within a profit maximising equilibrium. Optimality involves balancing the reduction in expected costs associated with regulatory breach with the excess cost of financing from increasing capital. We demonstrate that when the equilibrium probability of regulatory breach is less than one half, banks are expected to hold precautionary capital.