Bank Capital Requirements and the Riskiness of Banks: A Review

Banks are required to hold capital primarily as a buffer against future losses and in order to reduce the exposure of the deposit insurer. However, as regulators and researchers have recognized, changes in capital requirements also affect bank portfolio behavior. It is possible that increased capital requirements may lead banks to increase their riskiness and thus increase their expected losses or increase the potential exposure of the deposit insurer. The object of this article is to show that the impact of increased capital requirements depends on the extent to which deposit costs reflect bank portfolio risk.' In particular, we show that with risk-based deposit insurance, the incentives to increase leverage or portfolio risk in response to an increase in bank capital requirements are reduced. The article is organized as follows. First, we define bank capital and discuss the mechanisms William P. Osterberg is an economist and James B. Thomson is an assistant vice president and economist at the Federal Rese~e Bank of Cleveland.