Abstract
Using data for banks from 65 countries for the period 2001–2013, we investigate the impact of bank regulation and supervision on individual banks’ systemic risk. Our cross-country empirical findings show that bank activity restriction, initial capital stringency and prompt corrective action are all positively related to systemic risk, measured by Marginal Expected Shortfall. We use the staggered timing of the implementation of Basel II regulation across countries as an exogenous event and use latitude for instrumental variable analysis to alleviate the endogeneity concern. Our results also hold for various robustness tests. We further find that the level of equity banks can alleviate such effect, while bank size is likely to enhance the effect, supporting our conjecture that the impact of bank regulation and supervision on systemic risk is through bank’s capital shortfall. Our results do not argue against bank regulation, but rather focus on the design and implementation of regulation.
Highlights
The inappropriate regulations and ineffective monitoring and supervision by official agencies have been regarded as a critical cause of the global financial crisis of 2007–2009 (Goodhart 2008; Schwarcz 2008; Acharya 2009; Laeven and Levine 2009)
We find that bank activity restriction, initial capital stringency and prompt corrective action are positively related to systemic risk
We control for a set of bank-specific and country-specific variables in the regression analysis, including bank size, profitability, market-to-book value, loan loss provision, GDP growth, inflation and economic freedom, which have been used in some previous studies of bank regulation and risk (Barth et al 2004; Delis et al 2011; Anginer et al 2014a)
Summary
The inappropriate regulations and ineffective monitoring and supervision by official agencies have been regarded as a critical cause of the global financial crisis of 2007–2009 (Goodhart 2008; Schwarcz 2008; Acharya 2009; Laeven and Levine 2009). Our findings suggest that the increased similarity in the banking system due to the restrictions on non-banking activities would increase systemic risk This is consistent with the recent theoretical work on financial stability that highlights the importance of diversity in banking (Wagner 2010, 2011; Allen et al 2012), showing that some degree of diversification in banks’ asset portfolios is socially optimal so that banks do not have to liquidate their identical assets at the same time when financial shocks happen and generate a fire-sale externality that lowers welfare. Our paper does not directly test the effect of government capital injection to the financial system during crisis periods, the implication of our results is supportive of government action to reduce the capital shortfall of the banking system This is consistent with the empirical evidence provided by Berger et al (2019) that the U.S Troubled Assets Relief Program (TARP) significantly reduced banks’ contributions to systemic risk.
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