Endogenous Capital and Profitability in Banking

Abstract

This paper investigates the relation between bank capital and profitability. To my knowledge, no previous paper has analysed this problem in a two-equation structural model. Contrary to what is reported with surprising frequency in this field of research, the results show no statistically significant relationship between capital and profitability. Given non-binding capital requirements this finding is consistent with the view that, while raising capital is costly for banks, it is associated with compensating benefits that offset these additional costs. Consequently, when capital structure is endogenously determined in a profit maximising equilibrium, no systematic relation between capital and profit is expected.