Banks to Basics! Why Banking Regulation Should Focus on Equity
34 Pages Posted: 30 Apr 2020
Date Written: April 6, 2020
Banking regulation faces multiple challenges that call for rethinking the way it is designed. Not only does it have to tackle the specific risks associated with banking activities, but it is now expected from it to help dealing with climate change. In this paper, we argue that regulators should focus on designing strong equity requirements instead of implementing several complex rules. Such a constraint in equity is however opposed by the banking industry because of its presumed adverse impact on banks' performance. Resorting to Random Forest regressions on a large dataset of banks balance sheet variables, we show that the ratio of equity over total assets has a clear positive effect on banks' performance, as measured by the return on assets. On the contrary, the impact of this ratio on the shareholder value, as measured by the return on equity, is most of the time weakly negative. Strong equity requirements do not therefore impede banks' performance, but do reduce the shareholder value. This may be the reason why the banking industry so fiercely opposes strong equity requirements.
Keywords: Banking regulation, Capital requirements, Basel III, Random Forest regressions
JEL Classification: C44, G21, G28
Suggested Citation: Suggested Citation