Examining the Relationships between Capital, Risk and Efficiency in European Banking

TLDR

The study investigates the relationship between capital, risk, and efficiency among European banks from 1992 to 2000. The authors analyze a large sample of European banks over that period to examine these relationships. Unlike US evidence, the study finds no positive link between bank inefficiency and risk‑taking; instead, inefficient European banks hold more capital and take less risk, higher risk correlates with higher capital and liquidity, corporate sector strength reduces bank risk and capital, and cooperative banks show inverse capital‑risk relations with lower capital in inefficient banks, with variations across efficiency levels.

Abstract

Abstract This paper analyses the relationship between capital, risk and efficiency for a large sample of European banks between 1992 and 2000. In contrast to the established US evidence we do not find a positive relationship between inefficiency and bank risk‐taking. Inefficient European banks appear to hold more capital and take on less risk. Empirical evidence is found showing the positive relationship between risk on the level of capital (and liquidity), possibly indicating regulators' preference for capital as a mean of restricting risk‐taking activities. We also find evidence that the financial strength of the corporate sector has a positive influence in reducing bank risk‐taking and capital levels. There are no major differences in the relationships between capital, risk and efficiency for commercial and savings banks although there are for co‐operative banks. In the case of co‐operative banks we do find that capital levels are inversely related to risks and we find that inefficient banks hold lower levels of capital. Some of these relationships also vary depending on whether banks are among the most or least efficient operators.