BANK PERFORMANCE AND THE SHADOW PRICE OF CAPITAL

The equity-capital to assets ratio in banks has become a critical focus of attention in financial stability policy. An important aspect of this is the relationship between deleveraging and the return on equity capital which have become key areas in measuring the costs and benefits of bank re-capitalization; participants in the policy debate on financial stability are concerned with the costs of re-establishing the capital basis of many banks in Europe. In this paper we examine an important case study sample which may offer lessons for European policy makers; this is the evolution of the banking system in Japan over the period 2000-2010. Japan is one of the countries where the re-capitalization issue has already played a major role in policy making. One important aspect is that where many banks are unlisted, it is difficult to measure the cost of equity capital and to evaluate the policy debate. We offer a suggested way forward to providing an econometric estimate of the shadow rate of return on bank equity capital so that the re-capitalization issue can be analysed. Using a large panel data sample, we estimate the shadow return on equity capital for both listed and unlisted banks by measuring the loans-fundingequity technology through the dual cost function. We include measures of risk and non-performing loans in the analysis. The results enable us to calculate the productivity impacts of the variation over time in the shadow return on equity arising from the constraint on the balance sheet implied by the need to recapitalize. We offer policy conclusions and suggest how the models can be used to develop measures of market competition.