Do supervisory mechanisms or market discipline relate to bank capital requirements and risk-taking adjustment? International evidence

Abstract

This study proposed a modified method to investigate whether capital regulations have an effect on bank risk-taking, or whether their effects are channeled through supervisory mechanisms and market discipline. This study used data from 1,702 banks of 42 countries over the period 2000 to 2007 to verify the capital buffer theory (Marcus, 1984; Milne and Whalley, 2001). It was found that the empirical results supported the hypotheses proposed in this paper: (1) Banks with high capital buffer positions will adjust their capital adequacy ratio and risk-taking in the same direction; (2) Banks with low capital buffer positions will adjust their capital faster than banks with high capital buffers. The empirical results suggested that banks with stringent supervisory mechanisms tend to mitigate adjustments of the capital buffer, but take on higher credit risk-adjustments. However, the impact of market discipline was in the opposite direction. The results clearly suggested that regulations alone may not be adequate to control credit risk-taking and that thorough investigation of supervisory mechanisms and market discipline are also required. Furthermore, it appeared that ignoring the interactions between regulations and adjustment of capital and risk could lead to erroneous inferences about the impact of regulations on credit risk-taking. The results implied that incentives and tools that enhance market power self-monitoring could promote reductions in risk-taking. This paper attempted to provide some insights in the wake of the global financial tsunami. Key words: Supervisory mechanism, market discipline, credit risk-taking, capital buffer, regulation.