This paper analyzes the value maximization of regulated banks within a moral-hazard framework. In the model, regulators monitor both the capital ratio and the asset portfolio, and banks simultaneously select the optimum capital ratio and asset portfolio. A key assumption is that a bank cannot expect a positive put option value once it is classified as risky by regulators. The optimum values of the two variables depend on investment opportunities and charter values, as well as regulatory parameters. The model that explicitly incorporates regulation can explain various phenomena that are seemingly inconsistent with the predictions of moral hazard models — for example, a positive relationship between the capital ratio and the riskiness of the asset portfolio. A particularly interesting result is that a larger charter value results in a higher-risk interior solution

We examine whether U.S. banks subject to the Liquidity Coverage Ratio (LCR) reduce lending (an unintended consequence) and/or become more resilient to liquidity shocks, as intended by regulators. We find that LCR banks tighten lending standards, and reduce liquidity creation that occurs mainly through lower lending relative to non-LCR banks. However, covered banks also contribute less to fire-sale externalities relative to exempt banks. For LCR banks, we estimate that the total after-tax benefits of reduced fire-sale risk (net of the costs associated with foregone lending) exceed $50 billion from 2013Q2 to 2017, mostly accruing to the largest LCR banks. Non-LCR regulations enacted during our sample period cannot fully account for these findings. For the banking sector as a whole, lending migrates to smaller, non-LCR banks so that lending shares increase but fire-sale risk does not decrease. Our results highlight the trade-off between liquidity creation and resiliency arising from liquidity regulations that underlie the debate on whether the LCR should be extended following the banking crisis of March 2023

Using a sample from 38 economies, we examine the relation between bank regulators’ supervisory power and loan spreads. We find that loans issued by banks in economies with more powerful supervisors have higher spreads. The positive association is more pronounced when firms have lower credit quality, when the relationships between firms and banks are less established, when syndicate loans involve fewer lenders, and when lead banks have a riskier profile. Further analyses reveal that loans issued by banks that operate under more powerful supervisors have smaller size and shorter maturity, and the loans are more likely to have collateral requirements and restrictive covenants. Overall, these results suggest that stronger supervisory power of bank regulators affects loan contracting by mitigating lenders’ excessive risk taking

We investigate the liquidity management of 62 Dutch banks between January 2004 and March 2010, when these banks were subject to a liquidity regulation that is very similar to Basel III’s Liquidity Coverage Ratio (LCR). We find that most banks hold more liquid assets against their stock of liquid liabilities, such as demand deposits, than strictly required under the regulation. More solvent banks hold fewer liquid assets against their stock of liquid liabilities, suggesting an interaction between capital and liquidity buffers. However, this interaction turns out to be weaker during a crisis. Although not required, some banks consider cash flows scheduled beyond 1month ahead when setting liquidity asset holdings, but they seldom look further ahead than 1year

The barrier options theory of corporate security valuation is applied to the contingent claims of a regulated bank. The regulator/insurer of a bank owns a down-and-in call option on the bank assets which can be balanced against the expected coverage cost. Raising the regulatory barrier (critical asset level triggering bank closure) leads to a transfer of wealth from stockholders to the insurer and reduces stockholder incentives to increase asset risk. Empirical tests on a sample of 152 one-bank holding companies show that regulatory barriers are priced in the stock market and are inversely related to Tier 1 leverage ratios

This paper studies the consequences of a regulatory pay cap in proportion to assets on bank risk, bank value, and bank asset allocations. The cap is shown to lower banks’ risk and raise banks’ values by acting against a competitive externality in the labour market. The risk reduction is achieved without the possibility of reduced lending from a Tier 1 increase. The cap encourages diversification and reduces the need a bank has to focus on a limited number of asset classes. The cap can be used for Macroprudential Regulation to encourage banks to move resources away from wholesale banking to the retail banking sector. Such an intervention would be targeted: in 2009 a 20% reduction in remuneration would have been equivalent to more than 150 basis points of extra Tier 1 for UBS, for example

We discuss “Economic Consequences of Mandatory Auditor Reporting to Bank Regulators” by Balakrishnan, De George, Ertan, and Scobie (BDES, in this issue). BDES concludes that a key benefit of mandatory auditor reporting to bank regulators is reduced bank risk, and its costs include reduced profitability from less overall and less risky lending, and higher audit costs. BDES also provides evidence on the channels through which mandatory auditor reporting links to reduced bank risk. We scrutinize BDES's analyses and inferences and suggest additional analyses to improve and deepen them. Most notably, we caution that effective bank regulation entails reducing risk for riskier banks; risk reduction for safer banks suggests regulatory overreach. Our evidence is more indicative of regulatory overreach. Thus, although BDES is an important step forward in understanding the role auditors can and do play in improving information available to key decision-makers other than through auditor reports on financial statements and internal controls, a comprehensive assessment of whether the benefits of mandatory auditor reporting to bank regulators exceed its costs is left for future research. Such an assessment is necessary before concluding whether mandatory auditor reporting leads to more effective bank regulation or regulatory overreach

We develop a simple model of banking regulation with two policy instruments: minimum capital requirements and the supervision of domestic banks. The regulator faces a trade-off: high capital requirements cause a drop in the banks’ profitability, whereas strict supervision reduces the scope of intermediation and is costly for taxpayers. We show that a mix of both instruments minimises the costs of preventing the collapse of financial intermediation. Once we allow for cross-border banking, the optimal policy is not feasible. If domestic supervisory effort is not observable, our model predicts a race to the bottom in capital requirement regulation. Therefore, countries are better off by harmonising regulation on an international standard

This paper uses a panel database of 251 banks in 36 countries to analyze the impact of bank regulation on bank charter value and risk-taking. After controlling for deposit insurance and for the quality of a country's contracting environment, the results indicate that regulatory restrictions increase banks' risk-taking incentives by reducing their charter value. Banks in countries with stricter regulation have a lower charter value, which increases their incentives to follow risky policies. These results corroborate a negative relation between regulatory restrictions and the stability of a banking system. Deposit insurance has a positive influence on bank charter value, mitigating the risk-shifting incentives it creates. This positive influence disappears when we control for the possible endogeneity of deposit insurance

Based on the hand-collected board structure data of 277 listed banks across 55 countries, and the bank regulation and supervision database compiled by the World Bank, this paper provides the first cross-country assessment of the impacts of bank regulations on board independence of banks. In line with Beck et al. (2006), we examine the effects of two types of regulation policies, the first involving the empowerment of supervisory agencies to monitor and discipline banks directly, and the second focusing on encouraging private monitoring of banks through requiring disclosure of more accurate and complete information. We find that empowering official supervisory agencies to discipline banks directly reduces board independence, but encouraging private sector monitoring of banks increases it. The findings suggest that the first type of regulations tends to crowd out the internal governance of banks, while the second crowds in it. We also find that the legal system with better investor rights protection and better contracts enforcement not only increases board independence but also enhances the crowding in effect of promoting private monitoring and decreases the crowding out effect of direct official supervision on board independence