The Relationship Between Capital and Earnings in Banking

Conventional wisdom in banking suggests a higher capital-asset ratio (CAR) is associated with a lower after-tax return on equity (ROE). Despite the arguments in favor of this hypothesis, data on U.S. banks in the mid- to late-1980s tell a very different story. Bank values of CAR and ROE are positively related, and this relationship is both statistically and economically significant. The positive relationship between CAR and ROE holds both cross-sectionally and over time, holds when lags are included, and becomes even stronger when an extensive set of control variables is added to the regres-ions. The author regresses CAR and ROE on three years of lagged CAR and ROE and a number of control variables. The model suggests positive causation in the Granger sense to run in both directions between capital and earnings, consistent with the hypothesis that banks retain some of their marginal earnings in the form of equity increases. The evidence suggests that higher capital is followed by higher earnings over the next few years primarily through reduced interest rates on uninsured purchased funds. These findings are strongest for banks with low capital and high portfolio risk who decreased their portfolio risks as well as increased their capital positions relative to what they otherwise would have been. These results are consistent with the hypotheses that, because of factors making banks riskier in the 1980s, some banks may have had greater than optimal risk of bankruptcy and the associated deadweight liquidation costs, and as a result paid very high risk premiums on uninsured funds and suffered lower earnings. Those banks with increased expected bankruptcy costs that reacted by increasing capital quickly appear to have paid lower uninsured debt rates and had higher earnings than those that did not react this way. The tests generally do not support the signalling hypothesis - bank management signals private information that future prospects are "good" by increasing capital. The tests also show that the positive Granger-causality from capital to earnings of the 1980 does not apply to the 1990-1992 time period. The data suggest that banks may have "overshot" their optimal capital in the early 1990s because of regulatory changes, decline in bank risk, or unexpected high earnings that raised capital above optimal levels.