Research

How Does Capital Affect Bank Performance During Financial Crises? (Significantly expanded version of the second part of: Financial Crises and Bank Liquidity Creation)

Authors

• Christa Bouwman
• Allen Berger

Published

Journal of Financial Economics

Abstract

What does capital do for banks around financial crises? We address this question by examining the effect of pre-crisis bank capital ratios on banks’ ability to survive financial crises, and on their competitive positions, profitability, and stock returns during and after such crises. We distinguish between two banking crises and three market crises that occurred in the U.S. over the past quarter century, and examine small, medium, and large banks separately. The evidence suggests that capital helps small banks to survive banking and market crises, and helps medium and large banks to survive banking crises. Moreover, the manner in which a bank exits when it does not survive a crisis (e.g., because it is acquired with or without government assistance) also depends on its pre-crisis capital ratio. Higher capital enables banks of all size classes to improve their market shares during banking crises and these banks are generally able to maintain their improved shares afterwards. Around market crises, higher capital enables only small banks to improve their market shares. Similar, but weaker results are obtained based on profitability. Higher capital also led to higher abnormal stock returns for banks during one of the banking crises. During “normal” times between crises, most of the relative benefits of higher capital are experienced only by small banks. Overall, our results suggest that the importance of bank capital is elevated during crises, and particularly banking crises.