Bank capital and exposure to the financial crisis

We find that banks with more capital experienced more severe stock price declines during the recent financial crisis. We also find that banks with more capital experienced higher betas and stock volatility levels during the financial crisis. These results support the capital signaling hypothesis, in which under conditions of risk-based capital requirements, bank capital serves as an indicator of asset quality during the financial crisis. While capital is normally perceived to serve as a cushion even if asset risk is high, higher levels of capital were not sufficient to cover expected losses of banks with high asset risk levels during the financial crisis. Banks that maintained a lower level of marketable securities and relied less on fee income were damaged to a greater degree during the financial crisis. Furthermore, banks that were larger, experienced weaker operating performance and stock price performance prior to the crisis, and relied less heavily on fee income experienced more pronounced jumps in risk during the crisis.

► We propose that banks with more capital were more exposed during the financial crisis. ► The volatility of bank stock returns almost tripled on average during the financial crisis. ► Banks with more capital experienced larger shocks during the financial crisis. ► Banks that were more profitable before the crisis were more insulated from crisis shocks.