Does banking capital reduce risk? an application of stochastic frontier analysis and GMM approach

Abstract

In this chapter, we thoroughly analyze the relationship between capital and bank risk taking. We collect cross section of bank holding company data from 1993 to 2008. To deal with the endogeneity between risk and capital, we employ stochastic frontier analysis to create a new type of instrumental variable. The unrestricted frontier model determines the highest possible profitability based solely on the book value of assets employed. We develop a second frontier based on the level of bank holding company capital as well as the amount of assets. The implication of using the unrestricted model is that we are measuring the unconditional inefficiency of the banking organization. We further apply generalized method of moments (GMM) regression to avoid the problem caused by departure from normality. To control for the impact of size on a bank's risk-taking behavior, the book value of assets is considered in the model. The relationship between the variables specifying bank behavior and the use of equity is analyzed by GMM regression. Our results support the theory that banks respond to higher capital ratios by increasing the risk in their earning asset portfolios and off-balance-sheet activity. This perverse result suggests that bank regulation should be thoroughly reexamined and alternative tools developed to ensure a stable financial system.