3 Estimating economic bank capital buffers for euro area countries
The first step in the estimation of the impact of changes in economic banks’ capital buffers on banking variables and the macroeconomy is to estimate economic capital buffers per se. It is assumed that banks adjust their capital ratios towards a pre-specified or target level of economic capital ratio. The target level of economic capital ratio is the capital ratio that banks would like to hold considering their own characteristics and macroeconomic conditions.[5] However, owing to adjustment costs, a bank will adjust its actual capital ratio only slowly towards its desired target. See Box 1 for more details regarding the partial adjustment model used to estimate the target level of economic capital ratio.[6]
The target level of economic bank capital is assumed to fluctuate with banks’ characteristics and the business and financial cycle. Characteristics that affect the target level of economic capital in individual banks include banks’ total assets, their annual stock price growth rate and the volatility of each bank’s stock price. The first bank-level variable captures bank size, the second is a measure of bank profitability and the third reflects uncertainty to generate profits. These bank-level variables are standard determinants of bank capital ratios in the empirical literature.[7] At the same time, target capital ratios are assumed to be chosen for the purpose of absorbing expected future losses. As such, macroeconomic information relevant for assessing the probability of future losses is also considered in the regression. In particular, key macroeconomic variables that may affect how much capital a bank would like to hold to absorb future losses are the one-year ahead real GDP growth forecast for the country where the bank is located, the sovereign bond yield spread of that country and a euro area aggregate corporate bond high yield spread (the latter two variables reflect the opportunity cost of capital).
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