The Bank Capital Requirement and Information Asymmetry

This paper recognizes two main factors that cause the capital requirement to affect the weighted average cost of capital and hence the investment behavior ofbanks: underpriced debt resulting from the deposit insurance and information asymmetry between managers and the stock market. For a bank enjoying a low cost of debt (deposits), an increased proportion of equity financing raises the weighted average cost ofcapital. When the stock market underestimates the value of a bank due to information asymmetry, equity financing is expensive. This paper finds that banks constrained by the tightened capital requirement grew slower in 1991 and that information asymmetry as well as underpriced deposits played a role in explaining the slower growth.