The Optimal Level of Capitalization
The impact of Basel II on Bank Capitalization
The global financial crisis has highlighted the importance of prudential regulation of banks for ensuring stability of the global financial system. Yet, there is no consensus on the best way for regulating banks among both academic researchers and practitioners. This is especially true for setting the minimum level of regulatory capital. On the one hand, higher capitalization implies lower probability of failure. On the other hand, holding more capital restricts banks from earning higher profits, so they prefer holding less capital than is desirable from the regulators' perspective. Therefore, regulators impose capital restrictions on banks in order to prevent possible bank runs and large fiscal costs associated with the bailout of insolvent banks. Nowadays, Basel II is the most recent set of rules intended to achieve an optimal level of capitalization subject to the constraints imposed both by banks and regulators.
The theoretical literature on optimal regulatory capital restrictions in banking mainly analyses risk-weighted capitalization, where the required minimum capital held by banks increases with the riskiness of bank assets. However, the main practical issue with the risk-weighted bank capitalization is the assessment of risks, which is not straightforward. The most recent literature analyzes advantages and disadvantages of Basel II, which differs from the previous regulation by delegating the assessment of risks to banks themselves (internal rating based approach - IRB) on a voluntary basis. On the one hand, banks have better understanding of their risks than regulators and are expected to hold sufficiently high level of non-weighted capitalization (capital to assets ratio). Consequently, regulators don't need to spend money to design complicated models for assessing risks of banks. On the other hand, banks have incentive to artificially reduce the level of their asset risk in order to hold lower capital. Hence, the non-weighted capitalization of banks might decline under the new regulation. Which of these two effects dominates is not clear theoretically and remains an empirical issue to be tested on the data. Do banks that volunteer to use the IRB approach maintain lower capital holdings? As it will become apparent from this literature review, there is no study addressing this question empirically, partially because data on banks reporting capitalization using the IRB approach has become available only from 2008, when Basel II was enacted. Hence, the aim of the proposed research is to fill this gap in the literature and to provide an empirical assessment of the impact of Basel II on bank capitalization. If the hypothesis that banks reporting their capital using the IRB approach hold lower capital holdings is confirmed, then results of this study would call for reassessment of Basel II and introduction of non-weighted bank capitalization ratio to complement the current risk-weighted ratio, as suggested in.(责任编辑：BUG)