Bank capital regulation: How do Asian banks respond?

Abstract

Capital regulation is a primary focus of regulators to maintain the stability and credibility of the financial system. However, whether banks increase capital and reduce the risk to respond to the capital regulation is uncertain. Examining this issue on Asian banks during the period between 2002 and 2016, this study finds that capital regulation has a negative effect on bank capital and no influence on bank risk. Stricter capital regulation even increases the bank's probability of default. This is because the capital regulation reduces banks' per-period future profits and thus, harms their franchise value. This effect is also a result of the relative high capital ratios of Asian banks compared to the minimum requirements. We also find that market characteristics and the bank capital regulatory environment are less relevant to bank capital and risk behaviours. In addition, strengthening the regulation during the crisis period increases bank risk while inducing banks to focus more on improving the equity ratio and the asset quality during the Basel III revision period.