Faculty of Economics and Business Administration Publications Database

Market Structure, Capital Regulation, and Bank Risk Taking

Behr, Patrick
Xie, Ru
Volume: 37
Number: 2-3
Pages: 131 - 158
Month: June
ISSN-Print: 0920-8550
Link External Source: Online Version
Year: 2010
Keywords: Banks; Market structure; Risk shifting; Franchise value; Capital regulation
Abstract: This paper discusses the effect of capital regulation on the risk taking behavior of commercial banks. We first theoretically show that capital regulation works differently in different market structures of banking sectors. In lowly concentrated markets, capital regulation is effective in mitigating risk taking behavior because banks’ franchise values are low and banks have incentives to pursue risky strategies in order to increase their franchise values. If franchise values are high, on the other hand, the effect of capital regulation on bank risk taking is ambiguous. We then test the model predictions on a cross-country sample including 421 commercial banks from 61 countries. We find that capital regulation is effective in mitigating risk taking only in markets with a low degree of concentration. The results remain robust after accounting for financial sector development, legal system efficiency, and for other country and bank-specific characteristics.