Is Bank Capital Enough? Multi-Country European Evidence on Optimal Capital Ratios

This paper highlights the importance of solvency in preventing banking crises, in a financial system marked by rapid technological integration, underscoring the need for updated regulatory frameworks and supervisory tools to address emerging vulnerabilities. In this context, through the lens of countries that have experienced the European sovereign debt crisis, it has been possible to identify an optimal range of Tier 1 Capital Ratio and Solvency Ratio levels and to analyze systemic risk in four countries in Central Eastern Europe that have not experienced banking crises in the last two decades. The optimal Tier‑1 capital ratio is estimated to be between 16%-19% and the optimal solvency ratio to be around 17%-19%, where “optimal” denotes the levels that minimize the estimated probability of a banking crisis over 2- and 3-year horizon. Early warning systems for banking crises have been developed, confirming the importance of solvency indicators and enabling counterfactual analyses to be carried out. The latter showed that, on average, if the optimal levels identified had always been achieved during the sample period, the risk of crisis would have been minimal, below the alert threshold specific to the “no crisis” policy, at least in the case of the Tier 1 Capital Ratio. For Solvency Ratio, the counterfactual analysis shows that risk is close to the threshold only by controlling the credit cycle, indicating the importance of macroprudential measures to prevent boom-bust cycles.