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Capital Structure in Banks 141
management, 17 they need to hold (relatively) more capital (which is confirmed
in the data in Table 5.1). Additionally, other reasons may account for
the relatively lower leverage of smaller banks. 18 Smaller banks tend to have:
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More operating risk 19 due to the lack of management depth
A lack of fee-based income that has a stabilizing effect on the earnings
volatility, thus making risk management less necessary 20
A lack of diversification of their credit portfolios (with geographical
and/or industry concentrations).
Therefore, we can infer that the capital structure choice in banks is closely
related to the underlying risks held on the books of a bank. The role of
equity capital in banks is that of a substitute for transferring risk and, hence,
that of a buffer that protects the bank against costly unexpected shocks to
its capital base. 21 Equity capital, therefore, ensures a bank’s safety. 22
The Various Stakeholders’ Interests in Bank Safety As we have also seen in Chapter
2, all of a bank’s stakeholders have an interest in the safety of the bank,
but all have different views with regard to how much equity capital a bank
should hold. We will discuss these different views and which role equity
capital plays for all of the various stakeholder groups briefly below.
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Depositors/customers: Bank customers are those bank liability holders
who are most interested in the bank’s high credit quality, that is,
they would like no risk 23 associated with the repayment of their
17 It may not be worthwhile hiring an expensive risk professional for a part-time job.
18 See Davis and Lee (1997), p. 38.
19 Including business risk; for a definition see the “Operational Risk” section later in
this chapter.
20 Whereas an average of 38% of the earnings in the “>30 bn” bucket stem from feebased
income, only 18% do so in the “0.5–1 bn” bucket in Table 5.1.
21 These shocks are costly—as we saw in Chapter 3—when the financial distress costs
from high leverage are substantial and the transaction costs of raising new capital
quickly are high for the bank, that is, when total risk matters. See Berger et al. (1995b),
p. 398, also see Diamond and Rajan (1999), p. 4.
22 See Diamond and Rajan (1999), p. 4. Additionally, bank capital has an effect on
the bank’s ability to refinance at low cost and on the bank’s ability to extract repayment
from, or its willingness to liquidate, borrowers. See Diamond and Rajan (1999),
p. 42.
23 This is because customers usually do not want to be compensated for increases in
the bank’s credit risk. They prefer a safe repayment of their deposits. Moreover, for
many forms of deposits (e.g., checking accounts) no compensation for risk is possible
because no interest is paid.