Does the Intensity of Prudential Regulation Affect Banks? Evidence from the 2007-2009 Crises

Abstract

The main objective of this research is to gather empirical evidence on the effects of more or less stringency and more or less risk sensitivity in regulatory capital requirements on the observed behaviour of European banks during the initial years of the financial crisis. To do so, we use the indices built in Argimón and Ruiz (2010), which capture such characteristics of capital regulation. We test their incidence using changes in yearly data for individual banks for 25 countries of the European Union covering the period 2007-2009. Our results show that more stringency and risk sensitivity in capital regulation resulted in higher capital increases, with limited effect on risk taking. However, for well capitalized banks, higher risk sensitivity resulted in higher capital and higher risk, thus requiring striking the right balance, so as to lead to increased stability.

Keywords: Capital Ratios, Credit Risk, Financial Crisis, Prudential Regulation