Effects of Risk-Based Capital Requirements and Asymmetric Information on Banks' Portfolio Decisions

This paper examines if asymmetric information about earnings prospects caused low-capital banks to reduce assets rather than raise capital between 1989 and 1992, the transition period from the leverage ratio to the risk-based capital requirement. The measure of asymmetric information here is the residual of an earnings prediction model based on publicly available information. If managers are significantly better informed than outside investors, a large residual indicates that inside information is more favorable and that the bank's stock is undervalued. The empirical results show an insignificant effect of asymmetric information on banks' portfolio decisions.