Bank Equity Issues: Determinants, Costs, Systemic and Macroeconomic Effects

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The role of bank undercapitalization as an important determinant of the propagation of macroeconomic shocks through the financial system has been repeatedly illustrated by the most recent as well as earlier financial crises. Recognizing the risks of bank undercapitalization, policy makers have recently proposed a number of measures targeting higher levels of bank capital. An evaluation of the possible macroeconomic effects of the new capital rules is badly needed but still challenging since many aspects of bank capital decisions have not been thoroughly studied, yet. In particular, most existing research with regard to the effects of capital regulation has focused on studying banks decisions to adjust lending, leaving the decisions of banks to actively change the volume of equity widely unexplored. In this project we plan to close this gap and empirically examine the decision of a bank to issue new equity. More specifically, we intend to answer the following questions: (i) Which are the determinants of the decision of a bank to issue new equity? Do severe undercapitalization and systemic distress create effective incentives or disincentives with regard to the issuing decision? (ii) Does the information revealed by the equity issue of an individual bank have an effect on the behavior of the banks peers? Is this effect stabilizing or rather destabilizing the financial system as a whole? (iii) What is the interaction between a banks decision to issue equity and its asset dynamics? What does a structural estimation with regard to this interaction imply for the magnitude of the costs of issuing equity or liquidating bank assets? How do these costs affect the macroeconomic outcomes of stricter capital regulation? Could a regulatory framework be designed so that issuing costs are reduced and banks incentives to recapitalize are increased? The answers to these questions will contribute to a better understanding of the mechanism of the relation between bank capitalization and macroeconomic performance. They will also provide valuable information that can be used by researchers and policy makers when designing a regulatory framework that gives banks sufficient incentives to recapitalize thus reducing the risk of adverse macroeconomic outcomes.