Does Regulatory Regime Matter for Bank Risk Taking? A Comparative Analysis of US and Canada

Abstract

The banking structure in the US is less concentrated, more competitive and less restrictive, whereas that of Canada is more concentrated, less competitive, and more restrictive. In the wake of the worst financial crisis in 2008, most US banks were bailed out while Canadian banks sailed through the crisis relatively unscathed. We examine the risk taking behavior of banks in the US and Canada prior to the recent financial crisis and find that Canadian banks had lower risk than their US counterparts over the study period. Further analysis shows that entry restrictions, which create concentrated banking structure, restrictions relating to capital, liquidity and activities, and strong supervisory power and discipline positively related to the z-score, suggesting that these factors constrain excessive risk taking by Canadian banks. We also decompose the z–score into its components and re-estimate our baseline regression with the view to identifying the source of the risk. We find that entry restrictions (and higher concentration) generate higher profits and lower variability of asset returns for Canadian bank whiles restrictions on activities reduce profitability and increases variability in asset return; however, the former seems to overwhelm the effect of asset restriction, given the lower risk that we observe for the Canadian banks. The less concentrated but competitive banking structure in the US is associated with higher bank risk taking.