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Market Structure, Capital Regulation and Bank Risk Taking

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Abstract

This paper discusses the effect of capital regulation on the risk taking behavior of commercial banks. We first theoretically show that capital regulation works differently in different market structures of banking sectors. In lowly concentrated markets, capital regulation is effective in mitigating risk taking behavior because banks’ franchise values are low and banks have incentives to pursue risky strategies in order to increase their franchise values. If franchise values are high, on the other hand, the effect of capital regulation on bank risk taking is ambiguous. We then test the model predictions on a cross-country sample including 421 commercial banks from 61 countries. We find that capital regulation is effective in mitigating risk taking only in markets with a low degree of concentration. The results remain robust after accounting for financial sector development, legal system efficiency, and for other country and bank-specific characteristics.

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Notes

  1. The role of deposit insurance systems on risk taking behavior is, e.g., analyzed in Merton (1977), Bhattacharya and Thakor (1993) and Demirgüc-Kunt and Kane (2002).

  2. This is a simplifying assumption for modeling convenience. In practice, banks tend to operate with excess capital (e.g. Flannery and Rangan 2008; Berger et al. 2008).

  3. However, for convenience we will ignore the cost of deposit insurance for a bank when we calculate her net return.

  4. We may think of asset concentration, for instance the fraction of assets owned by the largest 5 banks, or deposit concentration.

  5. Laeven and Levine (2009) restrict their attention to the ten largest banks in each country. They argue that large banks tend to comply with international accounting standards and have liquid shares, reducing concerns that accounting or liquidity differences drive the results. We adopt their argumentation here but focus on the 20 largest banks instead.

  6. Table 9 in the Appendix contains all countries included in the analysis and the respective number of banks per country.

  7. Table 8 in the Appendix contains a description of all the variables used in the various regressions models and the sources the variables were extracted from.

  8. La Porta et al. (1998) use a similar index. As their index covers only the years 1980 to 1983, we decided to use the more recent one published by Kaufmann (2004).

  9. The effect of deposit insurance system is also controlled for and examined in González (2005) and Laeven and Levine (2009).

  10. Table 9 in the Appendix contains information about the number of banks and the value of the capital regulation stringency index per country.

  11. They are available upon request.

  12. In another robustness test, not reported here, we excluded banks from countries whose banking systems extend far beyond their borders like Belgium, Iceland, The Netherlands. The results are robust to this variation of the sample.

  13. For a formal treatment of the computation of the asset volatility we refer to the original source as well as to Hillegeist et al. (2004) and Vassalou and Xing (2004).

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Authors and Affiliations

  1. Chair of International Banking and Finance, Department of Finance, Goethe-University Frankfurt, Grüneburgplatz 1, 60323, Frankfurt, Germany

    Patrick Behr, Reinhard H. Schmidt & Ru Xie

Authors
  1. Patrick Behr
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  2. Reinhard H. Schmidt
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  3. Ru Xie
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Corresponding author

Correspondence to Patrick Behr.

Additional information

We thank Franklin Allen, Itay Goldstein, Reint Gropp, Hendrik Hakenes, Edward Kane, Lars Norden, an anonymous referee, Mark Flannery (the editor), seminar participants in Frankfurt, and participants at the annual meetings of the German Finance Association 2007 in Dresden, the Midwest Finance Association 2008 in San Antonio, and the Southwestern Finance Association 2008 in Houston for helpful comments. We further thank Ngoc Anh Vu for excellent research assistance.

Appendix

Appendix

Table 7 This table contains all questions we used for the construction of the capital regulation index which we use as a proxy for the overall capital regulation stringency. All questions and answers are taken from the survey conducted by Barth et al. (2008). Questions could either be answered with yes or no. We specify these answers as zero/one values, a value of 1 indicates a more stringent capital regulation. In questions 1, 2, 5–7, and 9–12 “yes” means more stringent and a value of 1 is assigned if the answer was “yes”. In questions 3, 4, and 8 “no” means more stringent and a value of 1 was assigned if the answer was “no”. The index was then constructed by running a principal component analysis
Full size table
Table 8 This table contains all bank- and country-level variables used in the empirical analysis. All variables are per year-end 2006 where available, and 2005 otherwise, apart from the Rule of Law and Corruption variables, which are averaged over the years 1982 to 1995, and the Judicial/Legal Effectiveness variable which is available per 2004
Full size table
Table 9 This table shows the number of banks and the value of the overall capital regulation stringency index per country divided into the two sub-samples for banks from markets in which asset concentration is low and banks from markets in which asset concentration is high
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Behr, P., Schmidt, R.H. & Xie, R. Market Structure, Capital Regulation and Bank Risk Taking. J Financ Serv Res 37, 131–158 (2010). https://doi.org/10.1007/s10693-009-0054-y

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