Overview

Managing risks has always been at the heart of any bank s activity. The existence of financial intermediation is clearly linked with a bank s advantage in evaluating the riskiness of potential borrowers and in building well-diversified portfolios. A bank s ability to survive adverse economic cycles (and phases of high volatility, as far as market risk exposure are concerned) is linked both to the quality of its risk selection and management processes and to its capital endowment. Capital is therefore a key resource for both shareholders and managers who are interested in a bank s ability to survive while offering an attractive return for shareholders. At the same time, capital is important for financial system supervisors who are interested in safeguarding the stability of the system by reducing the risk of bank failures (Berger, Herring, and Sz go 1995).

While the difference between the perspective of shareholders (who act as principals) and managers (who act as agents) when determining the optimal level of risk and the optimal amount of capital for the bank is common to any firm, the interest of supervisors in controlling the capital adequacy of industry players is typical of the financial sector. All developed countries have in fact witnessed through time, even if with partially different timetables from country to country, an evolution in financial supervision that has gradually favored increased competition in the banking business while strengthening prudential regulation. Capital ratios, in particular, have been considered the best solution to safeguard the soundness of the banking system, despite...