Market Risk-Based Capital Requirements, Trading Activity, and Bank Risk

49 Pages Posted: 3 Oct 2016 Last revised: 18 Sep 2017

See all articles by Dmytro Holod

Dmytro Holod

SUNY at Stony Brook University - College of Business

Yuriy Kitsul

Board of Governors of the Federal Reserve System

Gokhan Torna

SUNY at Stony Brook University - College of Business

Date Written: September 30, 2016

Abstract

This study investigates if market risk-based capital requirements (MRR) implemented in 1998 mitigated bank risk associated with trading activities. Recognizing that only banks with sufficiently high trading activities are subject to the MRR (regulated), we implement a difference-in-difference (DID) approach to show that in the post-MRR period, unregulated banks experienced an increase in risk associated with trading activity, while their regulated counterparts enjoyed no appreciable change in trading-related risk. We interpret the resulting negative DID coefficient as evidence of a risk-mitigating effect of the MRR. We also show that upon the implementation of the MRR, unregulated banks exhibit a significantly larger increase in contribution of opaque trading activity to bid-ask spreads, compared to regulated banks, for which the association between trading activity and bid-ask spreads actually declines. Our results are consistent with the view that the MRR significantly reduced moral hazard and adverse selection problems associated with opaque trading activities.

The views expressed in this paper are those of the authors alone and do not necessarily reflect the views of the Board of Governors of the Federal Reserve System, the Federal Reserve System, or their staff.

Keywords: Market Risk-Based Capital Requirements; Capital Regulations; Trading Activity; Systematic Risk; Idiosyncratic Risk; Information Environment

JEL Classification: G00, G20, G21, G28

Suggested Citation

Holod, Dmytro and Kitsul, Yuriy and Torna, Gokhan, Market Risk-Based Capital Requirements, Trading Activity, and Bank Risk (September 30, 2016). Journal of Banking and Finance, Forthcoming, Available at SSRN: https://ssrn.com/abstract=2846409 or http://dx.doi.org/10.2139/ssrn.2846409

Dmytro Holod

SUNY at Stony Brook University - College of Business ( email )

321 Harriman Hall
Stony Brook, NY 11794-3775
United States
631-632-7183 (Phone)
631-632-9412 (Fax)

HOME PAGE: http://ms.cc.sunysb.edu/~dholod/

Yuriy Kitsul

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Gokhan Torna (Contact Author)

SUNY at Stony Brook University - College of Business ( email )

250 Harriman Hall
Stony Brook, NY 11777
United States
631-632-5304 (Phone)
631-632-9412 (Fax)

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