Introduction

Abstract

Capital regulation in the form of minimum capital requirements is the most popular instrument in current banking regulation. The prevalence of minimum capital requirements is the result of a process of deregulation starting in the 1970s. In the course of deregulation, regulators have subsequently abolished, among other instruments, limitations on eligible banking activities and deposit rate ceilings. In order to limit the probability of default, they continued to require banks to hold a certain amount of capital measured as a percentage of total assets. The rationale was that capital acts as a buffer: As bank owners’ claims are subordinate to depositors’ claims, banks are solvent if their asset value is at least as high as depositors’ claims. In order to guarantee that funds are still available to pay back depositors and other creditors of a bank in the case of financial distress, minimum capital requirements introduce a higher artificial insolvency threshold. In the Savings and Loan Crisis in the US and in the Latin-American crisis, it became, however, apparent that minimum capital requirements that do not depend on banks’ asset risk are not sufficient to limit the probability of default. Hence, regulators tried to bind minimum capital requirements to banks’ asset risk by measuring capital as a percentage of risk-weighted assets.