Bank Capital and Monitoring: Evidence from Loan Quality

There are two competing theoretical perspectives on whether bank capital improves or adversely affects banks’ monitoring incentives. We show that bank capital is positively associated with loan quality, an outcome of bank’s monitoring effort, and two salary-based ex-ante measures of monitoring effort that capture quality and quantity of labor input into monitoring. The evidence is robust to a battery of additional tests including an instrumental variable approach. Overall, our evidence is consistent with the prediction in Mehran and Thakor (2011) that bank capital strengthens monitoring incentives which in turn increases loan quality and hence the value of its loan portfolio.