Capital regulation and bank behavior: Empirical evidence from Asia

Abstract

Capital regulation is one of regulators’ primary focus in assessing and controlling bank operations. Bank capital represents the shareholders’ benefits and induces them to manage risk properly. This effect is of great significance due to banks’ interconnectedness that quickly spreads the failure of a specific institution over the whole system. In addition, when losses occur, bank capital acts as the first absorber of loss and reduces the probability of bankruptcy. This can eventually reduce the likelihood and amount of any government bailouts, as well as a tax burden on citizens. However, given the high costs associated with capital, banks prefer to keep lower levels of capital. This study considers the effects of capital regulation on bank behavior. More specifically, it investigates bank responses to capital regulation to determine whether it encourages banks to operate safely or not. This study focuses on Asian banks, which have received limited scholarly attention, compared to the U.S and European countries. Given more convergence in implementing Basel III (international capital standards) among Asian countries, understanding the effects of capital regulation on bank behavior in these countries is of great importance. Firstly, we examine how capital regulation affects bank capital ratios by adopting the Partial Adjustment Model and employing two-step system Generalized Method of Moments (GMM) regression. Our study confirms that, during the study period (from 2001 to 2016), capital regulation is effective in inducing banks to raise their capital ratios (regardless of different measurements). Secondly, we investigate the effects of capital regulation on bank capital and risk behavior using a Simultaneous Equation Model with Partial Adjustment. The emphasis is on the existence of fixed effects, which are commonly ignored in prior studies. The results show that capital regulation exerts a negative effect on capital adjustments and has no effect on bank risk. Instead, bank capital and risk decisions are largely driven by bank characteristics such as size, profitability, lending, loan quality, tangibility, deposit ratios, and economic growth. Lastly, we investigate the effects of capital regulation on bank balance sheet adjustments in a dynamic and simultaneous model using two-step system GMM. Our empirical results show that capital regulation induces banks to reduce adjustments in shareholder capital and lending, while leading to an increase in investment and other asset adjustments. Nevertheless, these effects of capital regulation vary significantly across developed, emerging, and frontier countries, as well as across Basel Committee members and non-member countries. Our results are based on a newly proposed measurement of capital regulation, namely the Advanced Capital Regulation Index. This index was designed to reflect both quantitative and qualitative aspects of capital regulation and thus, is capable of capturing most of its effects. The analyses proved the usefulness of this index over the traditional measurements. Our results also suggest some scope for capital regulation reforms, including a simplified leverage ratio, a greater emphasis on new equity raising, more national discretion, an enhancement of risk-weight standards, risk level constraints, and reinforcement of supervisor review process.