The effects of regulatory stringency and risk sensitivity on banks

Abstract

The EU's transposition of Basel II into European law has been done through the Capital Requirements Directive. Although the Directive establishes, in general, uniform rules to set capital requirements across European countries, there are some areas where the Directive allows some heterogeneity. In particular, Member States are asked to choose among different possibilities when transposing the Directive, which are called national discretions (ND). The main objective of our research is to use such observed heterogeneity to gather empirical evidence on the effects on European banks of more or less stringency (ST) and more or less risk sensitivity (RS) in capital requirements. Following the approach in Barth et al, we build index numbers for groups of ND, and applying the approach in Altunbas et al we provide evidence on their effect on banks’ risk, capital, efficiency and costs. We show that more ST and more RS in regulation does not always result in a trade-off between efficiency and solvency: the impact depends on the area of ND to which such characteristics apply.