Capital and Risk Adjustments Under Risk-Based Capital Regulations and Diversification Loss

Abstract

In the last two decades, regulators have focused on the enforcement of minimum capital requirements on banks. Excessive risk-taking might otherwise have been encouraged by the principle of limited liability and by the availability of deposit insurance. Strengthened capital regulation has resulted in improved capital ratios for banks, and a more stable financial system. However, the changes to the regulatory system have been criticised on the grounds that an increased regulatory capital standards may encourage an increase in leverage and portfolio risk. Both the theoretical literature and the empirical literature on the impact of capital regulation have produced heterogeneous results concerning the capital and risk adjustment behaviour of banks. This study uses a cross-sectional time-series data set on commercial banks that is longer and more recent than in most other studies. We estimate the effect of changes in portfolio risk on the capital adjustment and of risk-based capital regulation on portfolio risk adjustment, using a simultaneous equations model. We find support for the capital buffer theory, which suggests that banks increase their capital holdings in response to an increase in portfolio risk, in order to avoid regulatory penalties. We also find evidence that banks increase their loan portfolio concentration in order to increase their regulatory capital ratios, suggesting that improvements in capital ratios are achieved at a cost in terms of the degree of diversification of the banks' loans portfolios.