“How Do the Minimum Capital Requirements Affect Banking Competition and Profitability?”

Louie (Yi) Liu, The University of California, Irvine

 

This paper examines why U.S. banks hold significantly more equity capital than the minimum required by the government. The theoretical model shows that in competitive market, banks choose the optimal capital ratios to trade off the cost and benefit to maximize their profits; the Minimum Capital Requirements (MCR) are likely to be an important factor on the bank's optimal choice and the target ratios decrease with banks' size.  Using a sample of US banks from 2002 to 2015, the empirical works finds that the relation between capital and profitability is dynamic and nonlinear:  it's an inverted U shape. This paper also takes the Industrial Organization (IO) approach to analyze the collusive effects of MCR on the oligopolistic market. Banks may collude to hold even higher capital ratios in the oligopolistic market since the capacity constraints caused by MCR reduce the competition.