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

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.