According to Alencar (2011), capital buffer theory
, which favors holding capital above the minimum level required by regulators, has gained popularity among theories which study capital requirements and the adjustment of banks' portfolios.
In attempting to understand and evaluate the effect of regulatory interventions on bank solvency, a new line of research on capital buffer theory has shown that a typical bank's capital cushion may be driven by the explicit and implicit costs of prudential regulation.
Unlike traditional moral hazard lines, the models of the capital buffer theory (Furfine, 2001; Milne & Whalley, 2001; Peura & Keppo, 2006) take capital as an endogenous response to regulation and add an intertemporal perspective to the bank's recapitalization process.
Milne and Whalley (2001) extend the behavioral model of the buffer theory, adding to the capital regulation restrictions the audit function of the supervisor agent.
The recently formalized capital buffer theory, however, proposes relationships among capital, risk, and regulation that seem more aligned to the evidence in the empirical literature.
As intended by financial authorities and consistent with the capital buffer theory, banks are expected in the short term to experience greater regulatory pressure to adjust their capital levels upwards and to take less risk in their portfolios (Hypothesis H1, tested by Specifications II).
The capital buffer theory suggests that banks with more liquid assets (LIQUID) need less insurance against breaches of capital requirements.
These results contradict the propositions of the capital buffer theory in which the liquidity cushion can replace capital as insurance against violations of the minimum capital requirement.