The Banking and Finance Review

Do Capital Standards Promote Bank Safety? Evidence from Involuntary Recapitalizations

Vinod S Changarath, Michael F Ferguson, Yong H Kim

Abstract


Regulators demand that weakly capitalized banks raise additional capital with the goal of reducing the public’s exposure to bank risk-taking.  This paper finds that involuntary bank equity issues during 1995-2008 are associated with significantly negative announcement returns.  These negative returns are greatest when the option value of the government’s deposit guarantee is most greatly reduced.  Consistent with the regulator’s policy goal, this implies a wealth transfer from the bank’s equity holders to the deposit insurer. However, it is also found that the negative returns are strongly related to the dilution of the insider owners’ equity stake.  This suggests insider moral hazard may be exacerbated by the equity issue.  Consistent with this notion, subsequent declines in operating performance and survival rates are also found to be strongly related to declines in the insider’s ownership position.  This suggests that capital standards, to some degree, shift bank failure risk from the near term to future periods.


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