Larry D. Wall and Pamela P. Peterson
Economic Review, Vol. 83, No. 2, 1998

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A system of bank supervision and regulation should protect taxpayers and the financial system without imposing unnecessary costs on banks. This article focuses on whether existing capital regulations, one of the primary tools of bank supervision and regulation, are imposing unnecessary costs on banks. In particular, the capital requirements may be requiring banks to issue equity when it would be less costly for them to issue subordinated debt.

The authors obtain evidence on the costs generated by equity issues by examining the type of capital banks issued in response to the capital guidelines of the 1980s, which included a type of debt in capital. The findings suggest that banks prefer to avoid issuing common equity, especially when the ratio of the market price of their stock to its book value is less than one. The results suggest that the option to substitute debt for equity in meeting the capital standards is especially valuable for banks with low market values. The results also suggest that the ability to issue debt as a substitute for equity is more valuable to larger banks.

June 1998