Market Structure, Capital Regulation and Bank Risk Taking

Posted: 17 Feb 2009

See all articles by Patrick Behr

Patrick Behr

Getulio Vargas Foundation (FGV) - Brazilian School of Public and Business Administration (EBAPE)

Reinhard H. Schmidt

Goethe University Frankfurt - Chair of Banking and Finance

Ru Xie

University of Bath, School of management

Date Written: February 16, 2009

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 as banks lack those incentives. 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 effciency, and for other country and bank-specific characteristics.

Keywords: Banks, market structure, risk shifting, franchise value, capital regulation

JEL Classification: G21, G28

Suggested Citation

Behr, Patrick and Schmidt, Reinhard H. and Xie, Ru, Market Structure, Capital Regulation and Bank Risk Taking (February 16, 2009). Journal of Financial Services Research, Forthcoming. Available at SSRN: https://ssrn.com/abstract=1344212

Patrick Behr

Getulio Vargas Foundation (FGV) - Brazilian School of Public and Business Administration (EBAPE) ( email )

Brazil

Reinhard H. Schmidt

Goethe University Frankfurt - Chair of Banking and Finance ( email )

Mertonstr. 17
P.O. Box 11932
60054 Frankfurt (Main)
Germany

Ru Xie (Contact Author)

University of Bath, School of management ( email )

Claverton Down
Bath, BA2 7AY
United Kingdom

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