Reaction of savings and loan share prices to increased capital requirements.

On November 28, 1988, the Federal Home Loan Bank Board (FHLBB) announced proposed changes in capital requirements for thrifts. These requirements were designed to be phased in and to take full effect by January 1, 1993. According to a report in the November 29, 1988, edition of The Wall Street Journal, the proposed rules would raise the average capital requirement to 8 percent of assets from a current range of 3 percent to 6 percent. The amount of capital required would be determined by the risk level assigned to certain types of loans and to a thrift's level of interest rate exposure. Specifically, investments in equities would be considered six times more risky than residential mortgages and three times more risky than commercial loans, thus requiring a higher capital level. Furthermore, thrifts that recognize goodwill as an asset would have to maintain four times the capital that would be required for an equivalent amount of residential mortgage assets. Moreover, the proposed rules would give the FHLBB' the power to take control of a thrift if its capital level falls below 1.5 percent of assets. The new rules would require thrifts to perform a sensitivity analysis to determine how their respective values would be affected by a 2 percent interest rate fluctuation. Based upon the results of this analysis, additional capital would be required to offset any additional interest rate risk exposure.

The article also stated that Danny Wall, chairman of the FHLBB, predicted that this proposal would "impact balance sheets around the country," and officials of the FHLBB believed that the provisions of these proposed rules would tighten hitherto lax lending practices. However, the Board recognized that discounting goodwill would inhibit mergers and acquisitions of ailing thrifts and perhaps discourage the smooth absorption of troubled institutions.

With the advant of the thrift industry's problems in recent years, several of these proposals emerged at various points in time, some mustering greater support and popularity than others. Among the myriad of proposed solutions that have emerged over the years, one stands out as perhaps having particularly significant and pervasive effects on the savings and loan industry, that of higher capital requirements. Equally convincing arguments exist for and against higher capital requirements for thrift institutions, but accurately assessing the true preference of the market can only be determined empirically.

The objective of this study is to determine the market's reaction to this November 28, 1988, announcement, in which the FHLBB proposed higher capital standards for savings and loan institutions. The results of this study may, by implication, indicate investors' preferences for or dislike of regulatory influence.

ARGUMENTS FOR HIGHER CAPITAL REQUIREMENTS

A higher proportion of capital results in less financial leverage and, therefore, more stable earnings, less risk of insolvency, and a greater ability to withstand the effects of rising interest rates. Thus, thrifts are perceived to be less risky from both the depositors' and investors' perspective. Wall [44, 45] states that the probability of failure is significantly affected by the level of capital.

Thrifts have traditionally maintained capital representing about 3 percent of assets, whereas banks are required to maintain their capital level closer to 6 percent of assets. Thrifts with such low proportions of capital are exposing themselves and their depositors to high risk. From a safety standpoint, thrifts should be required to maintain higher levels of capital, at least as high as that of banks. For banking institutions, capital regulations are imposed to ensure that they can weather unexpected losses [11]. Federal Reserve Board Chairman Alan Greenspan said, "It is essential that thrifts achieve and maintain at least the minimum capital adequacy standard applicable to banks" [10]. One could argue that thrifts should be required to maintain higher capital levels than banks do, as thrifts generally are more vulnerable to interest rate risk. This vulnerability stems from the wider gap that exists between thrifts' rate sensitive assets and rate sensitive liabilities. A generally accepted guideline is that for each 10 percent of negative gap, an institution should have an additional 1 percent of capital to withstand periods of high interest rates [23].

Whether stricter capital requirements should be applied across the board or be based on an individual institution's risk level is a debatable issue. Kim and Santomero [20] suggest that "the recent …