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Banking Competition and Capital Ratios
Authors:Klaus Schaeck  Martin Cihák
Affiliation:1. Bangor Business School, Hen Goleg, College Road, Bangor LL57 2DG, UK E‐mail: klaus.schaeck@bangor.ac.uk;2. International Monetary Fund, 700 19th Street, N W, Washington, D. C. 20431, USA E‐mail: mcihak@imf.org
Abstract:Empirical studies provide evidence that bank capital ratios exceed regulatory requirements. But why do banks maintain capital levels above regulatory requirements? We use data for more than 2,600 banks from 10 European countries to test recent theories suggesting that competition incentivises banks to maintain higher capital ratios. These theories also predict that banks that engage in arm's length lending have lower capital ratios, and that shareholder rights and deposit insurance characteristics affect capital ratios. Consistent with these theories, our evidence robustly indicates that competition increases capital holdings. Banks that lend at arm's length exhibit lower capital ratios, whereas banks in countries with strong shareholder rights operate with higher capital ratios. We also show some evidence that generous deposit protection schemes that exclude non‐deposit creditors are associated with higher capital ratios. Our results have important policy implications. First, while the traditional view suggests imposing restrictions on bank activities in order to restrain competition, our analysis indicates the opposite, even after adjusting the regressions for risk‐taking. Second, weak shareholder rights undermine market forces that would otherwise encourage banks to hold higher capital ratios.
Keywords:bank capital  regulation  competition  deposit insurance  shareholder rights  G21  G28  L11
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