Chapter 13 - Capital Regulation, Efficiency, and Risk Taking: A Spatial Panel Analysis of US Banks

Abstract

In this study, we empirically assess the impact of capital regulations on capital adequacy ratios, portfolio risk levels, and cost efficiency for US banks. Using a large panel data of US banks from 2001 to 2016, we first estimate the model using two-step generalized method of moments (GMM) estimators. After obtaining residuals from the regressions, we propose a method to construct the network based on the clustering of these residuals. The residuals capture the unobserved heterogeneity that goes beyond systematic factors and banks’ business decisions that affect its level of capital, risk, and cost efficiency and therefore represent unobserved network heterogeneity across banks. We then estimate the model in a spatial error framework. The comparisons of fixed effects, GMM fixed effect models with spatial fixed effects models provide clear evidence of the existence of unobserved spatial effects in the interbank network. We have found that a stricter capital requirement causes banks to reduce investments in risk-weighted assets, but, at the same time, increase holdings of nonperforming loans, suggesting the unintended effects of higher capital requirements on credit risks. We also find the amount of capital buffers has an important impact on banks’ management practices even when regulatory capital requirements are not binding.