Supervisory Mechanisms, Market Discipline Power, Bank Capital, and Risk-Taking Adjustments

Abstract

The recent crisis of European bond market has exposed a weakness in risk taking in the financial system, and suggests that financial authorities need to improve the effectiveness of supervisory and disciplining factors of risk taking. This paper proposes a modified model to investigate whether capital regulations affect bank capital and risk-taking adjustments, and whether these effects channel through supervisory mechanisms or market discipline power. This study employs data from 981 commercial banks in 21 Basel member countries and 371 commercial banks in 16 non-Basel member countries over the period from 2008 to 2010 to verify capital buffer theory following the global financial tsunami triggered by the 2007 subprime mortgage crisis.The results show that the effects of capital adjustments on risk and vice versa are both negative and highly significant, thus indicating that the coordination of capital and risk adjustments is an opposite two-way relationship. In addition, banks with high capital positions generally adjust their capital and risk-taking faster than banks with low capital ratios. However, banks with low capital buffer positions adjust their capital ratio and risk taking in opposite directions from these countries. The results indicate that capital requirements are effective tools for increasing capital and reducing risk-taking by banks, confirm the complementary role of supervisory mechanisms and market discipline power on capital regulation, and verify that banks strengthened by governance effectiveness tend to mitigate risk-taking adjustments. The results are consistent with our expectations for supervisory mechanisms, and appear to affect capital and risk adjustments. That is, the results exhibit that greater strength of supervisory mechanisms result in banks having less capital adjustments, but motivating them to take higher risks. These results provide important implications for banking supervision and regulation in developing policy responses following a crisis period after the implementation of new Basel Capital Accord.