The Inventory Perspective on Bank Capital

43 Pages Posted: 13 Aug 2004

See all articles by Alistair Milne

Alistair Milne

Loughborough University - School of Business and Economics

Date Written: August 2004

Abstract

This paper models bank capital management assuming illiquid assets, stochastic cash flow, and fixed costs of equity issue. Banks with sufficient franchise value (expected cash flow) maintain a buffer of capital in excess of regulatory requirements. The desired buffer is a non-monotonic function of franchise value. Incentives for risk taking depend upon this buffer not the absolute level of capital. Capital requirements have little long run effect on bank risk-taking. Negative cash flow and higher capital requirements reduce bank lending and risk-taking, with greatest impact on severely undercapitalized banks. Risk-preference and looting emerge under random audit.

Keywords: Capital buffers, capital regulation, capital dynamics, capital management, capital structure, cash flow, endogenous capital, financial distress, franchise value, looting, moral hazard, transaction costs

JEL Classification: G21

Suggested Citation

Milne, Alistair K. L., The Inventory Perspective on Bank Capital (August 2004). Cass Business School Research Paper, Available at SSRN: https://ssrn.com/abstract=576062 or http://dx.doi.org/10.2139/ssrn.576062

Alistair K. L. Milne (Contact Author)

Loughborough University - School of Business and Economics ( email )

Epinal Way
Loughborough
Leicestershire, LE11 3TU
United Kingdom

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