What is the optimal capital ratio implying a stable European banking system?

• Published date: 01 December 2023
• Author: Petr Jakubik,Bogdan Gabriel Moinescu
• Date: 01 December 2023
• DOI: http://doi.org/10.1111/infi.12438

Received: 18 October 2021

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Accepted: 6 September 2023

DOI: 10.1111/infi.12438

ORIGINAL ARTICLE

What is the optimal capital ratio implying a

stable European banking system?

Petr Jakubik

1

|Bogdan Gabriel Moinescu

2

1

Institute of Economic Studies, Faculty of

Social Sciences, Charles University in

Prague, Prague, Czech Republic

2

National Bank of Romania and

Bucharest University of Economic

Studies, Bucharest, Romania

Correspondence

Petr Jakubik, Institute of Economic

Studies, Faculty of Social Sciences,

Charles University in Prague, Opletalova

26, 110 00 Prague, Czech Republic.

Email: jakubik@fsv.cuni.cz,

petrjakubik@seznam.cz

Funding information

The Czech Science Foundation,

Grant/Award Number: GA 23‐05777S

Abstract

This paper aims to determine the ‘new normal’for

banking stability in terms of capital adequacy, review-

ing the incidence of banking stress episodes by lagged

solvency ratios, based on the experience at the

European level after the global financial crisis. We

provide rating ladders for both risk‐weighted solvency

ratios and a simple gearing (leverage) ratio for time

horizons of up to 3 years using well‐known credit risk

scoring procedures. Our findings empirically confirm

that the recent dual metric structure of the capital

adequacy framework is conducive to enhancing the

accuracy of banking stability assessment. Specifically,

our empirical analysis suggests that both tier 1 capital

ratio and leverage ratio generally remain statistically

significant in multivariate combinations for crisis

probability measurement purposes. Robustness checks

with well‐established macrofinancial indicators as

control variables suggest that this tandem is hardly

replaceable in multivariate early warning systems by

combinations of macroimbalance and financial sound-

ness indicators traditionally employed as leading

factors of banking crises. Moreover, the pandemic

period provides meaningful evidence that robust

capital positions, in line with our estimate, have so

far been ‘part of the solution’for dealing with systemic

events.

International Finance. 2023;26:324–343.wileyonlinelibrary.com/journal/infi324

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This is an open access article under the terms of the Creative Commons Attribution License, which permits use, distribution and

reproduction in any medium, provided the original work is properly cited.

© 2023 The Authors. International Finance published by John Wiley & Sons Ltd.

KEYWORDS

banking crises, banking supervision, early warning indicators,

optimal bank capital, risk assessment tool

JEL CLASSIFICATION

G01, G21, G28

1|INTRODUCTION

While the legacy of the ‘pragmatic exercise’employed in the late 1980s by the Basel Committee

on Banking Supervision (BCBS) to set the capital requirement at 8%, as described by Goodhart

(2011),

1

has endured more than three decades, this minimum level still appears ‘arbitrary’

because it does ‘not flow from any particular insolvency probability standard’(Greenspan, 1998).

Although it is generally accepted that higher capital levels are consistent with larger loss‐

absorbing capacity and lower probability of default, the optimal bank capital remains an open

question,

2

despite the growing academic literature dealing with this issue, especially following

the global financial crisis (GFC).

In a seminal report on the long‐term impact of higher capital ratios, BCBS (2010) concluded

that the long‐run net economic benefits would be close to 2% of GDP in a scenario where the

tangible common equity (TCE) to risk‐weighted assets (RWA) ratio rises to 10%, under the

hypothesis of no permanent effects of banking crises. However, this estimate increases to

13%–15%, when moderate permanent effects are considered, which roughly translates into

16%–19% in terms of Tier 1/RWA (Basel III) for samples of Euro‐area and UK banks, according

to Brooke et al. (2015). In a more recent review, BCBS (2019) finds, nevertheless, that ‘the net

benefits of higher capital requirements may have been understated in the original assessment’,

as new research (Almenberg et al., 2017; Barth & Miller, 2018; Brooke et al., 2015; Cline, 2016;

FED, 2017; Firestone et al., 2017; Miles et al., 2011)

3

provides occasionally even higher optimal

levels. However, the results put forward by these recent studies, which are mostly country‐

specific and based on general equilibrium models, vary considerably, namely from 10% to 25%

in terms of tier 1 capital ratio, with fairly wide ranges even within themselves, ‘reflecting the

myriad alternative assumptions used’.

4

Moreover, BCBS (2019) concludes that the link between

capital and the cost and probability of crises warrants further monitoring and research.

Additional results published by the European Central Bank (ECB) and the International

Monetary Fund (IMF), based on credit portfolio stress‐testing approaches, fit into the same

picture. Considering the risk of banking crises driven by borrower defaults, Mendicino et al.

(2021) find that capital requirements of around 15% provide the optimal trade‐off between

lowering the frequency of banking crises in the euro area and maintaining the availability of

credit in normal times. However, when firm default risk is assumed less diversifiable at the

bank level, ‘the optimal capital requirement needs to be substantially higher, i.e. close to 20%’

(Mendicino et al., 2020). Starting from the observed level of nonperforming loans ratios during

banking crises, Dagher et al. (2016) suggest that a solvency ratio between 15% and 23% of risk‐

weighted assets

5

‘would have been sufficient to absorb losses in the majority of past banking

crises (at least in advanced economies)’, for levels of loss given default (LGD) assumed from

50% to 75%. Hence, these alternative approaches generate similar wide ranges of optimal bank

capital with those suggested by general equilibrium models previously described.

JAKUBIK and MOINESCU

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