This paper develops a model of regulated Brownian motion with an endogenous profit term to analyze the role of regulatory credibility on the stability and productivity of the banking system. We show that when regulatory intervention is perfect and costless, the volatility of the system can be substantially reduced with no loss of productivity. In fact, perfect credibility can actually reduce the volatility of intrinsically risky banking systems below the volatility of intrinsically less risky systems as banks anticipate intervention and mitigate their investment behaviour accordingly. However, when the credibility of the regime is weakened because of increased uncertainty stemming from regulation, such as random costs or imperfect timing of regulatory intervention, both the stability and productivity of the financial system are impaired. Importantly, we find that in the presence of regulatory costs and imperfect credibility, there is no universal optimal intervention policy rule. The optimal regulatory system depends on the regulator’s level of absolute risk aversion

This paper provides evidence on how the new international regulation on Global Systemically Important Banks (G-SIBs) impacts the market value of large banks. We analyze the stock price reactions for the 300 largest banks from 52 countries across 12 relevant regulatory announcement and designation events. We observe that the new regulation negatively affects the value of the newly regulated banks, yet that the official designation of banks as “globally systemically important” itself has a partly offsetting positive impact. A cross-sectional analysis of the valuation effects with respect to, for example, government ownership of banks supports the view that the positive reaction to these designations can be attributed to a Too-Big-to-Fail (TBTF) perception by investors. The fact that these valuation effects emerge from a regulation specifically designed to reduce the costs and risks of Too-Big-to-Fail demonstrates the inherently paradoxical nature of the new regulation. These results further suggest that even though the individual components of the regulation have been effective, revealing the identities of G-SIBs eliminated ambiguity about the presence of government guarantees, and thereby may have run counter to the regulators’ intent to contain the effects of TBTF

Banks are subject to capital requirements because their privately optimal leverage is higher than the socially optimal one. This is in turn because banks fail to internalize all costs that their insolvency creates for agents who use their money-like liabilities to settle transactions. If banks can bypass capital regulation in an opaque shadow banking sector, it may be optimal to relax capital requirements so that liquidity dries up in the shadow banking sector. Tightening capital requirements may spur a surge in shadow banking activity that leads to an overall larger risk on the money-like liabilities of the formal and shadow banking institutions

Banks are subject to capital requirements because their privately optimal leverage is higher than the socially optimal one. This is in turn because banks fail to internalize all costs that their insolvency creates for agents who use their money-like liabilities to settle transactions. If banks can bypass capital regulation in an opaque shadow banking sector, it may be optimal to relax capital requirements so that liquidity dries up in the shadow banking sector. Tightening capital requirements may spur a surge in shadow banking activity that leads to an overall larger risk on the money-like liabilities of the formal and shadow banking institutions

In this paper, we analyze whether regulation reduced risk during the credit crisis and the sovereign debt crisis for a cross section of global banks. In this regard, we examine distance to default (Laeven and Levine, 2008), systemic risk (Acharya et al., 2010), idiosyncratic risk, and systematic risk. We employ World Bank survey data on regulations to test our conjectures. We find that regulatory restrictions, official supervisory power, capital stringency, along with private monitoring can explain bank risk in both crises. Additionally, we find that deposit insurance schemes enhance moral hazard, as this encouraged banks to take on more risk and perform poorly during the sovereign debt crisis. Finally, official supervision and private monitoring explains the returns during both crisis periods

In light of the ongoing restructuring of the European banking industry and the challenging macroeconomic environment, banks have increased their efforts to reduce operating costs. Yet, the institutional features that affect banks’ ability to adjust costs and in particular personnel expenses, which comprise a significant part of banks’ non-interest cost structure, have not been adequately studied. This paper investigates the effect of labour market institutions and regulations on bank performance in 15 European countries over the period 2005–2010, using the Fraser index for labour regulation and its disaggregated sub-components. We propose a novel methodology to measure performance, based on the seminal work of Kumbhakar and Tsionas (2005), which allows the estimation of technical and allocative efficiency and the examination of the effect of labour market regulations in a single stage. Results indicate the existence of a positive relationship between the liberalisation of EU labour markets and allocative efficiency, while the effect on technical efficiency appears to be negative, although not statistically significant. When looking at the disaggregated components of the labour index, we further confirm that different forces are at play

We investigate the effects of credit ratings-contingent financial regulation on foreign bank lending behavior. We examine the sensitivity of international bank flows to debtor countries’ sovereign credit rating changes before and after the implementation of the Basel 2 risk-based capital regulatory rules. We study the quarterly bilateral flows from G-10 creditor banking systems to 77 recipient countries over the period Q4:1999 to Q2:2013. We find direct evidence that sovereign credit re-ratings that lead to changes in risk-weights for capital adequacy requirements have become more significant since the implementation of Basel 2 rules for assessing banks’ credit risk under the standardized approach. This evidence is consistent with global banks acting via their international lending decisions to minimize required capital charges associated with the use of ratings-contingent regulation. We find no evidence to suggest that banking regulation induced foreign lending has heightened the perceived sovereign credit risks of recipient countries

Basel regulators have received widespread criticism for failing to prevent two credit crises that hit the U.S. over the last two decades. Nonetheless, banks were considerably overcapitalized prior to the onset of the 2007–2009 subprime crisis compared to those which had undergone the 1990–1991 recession. Therefore, if capital requirements were achieved prior to the subprime crisis, how could the Basel framework be blamed again for having accelerated if not caused another credit crunch? We find that the answer to this question lies in the relationship between the capital ratio and the leverage ratio which is governed by risk-weights categories determined by the Basel regulation. We show that changes to risk-weight categories which affect the correlation pattern between both ratios are not reflected in the subprime crisis. This minimizes the implication of the Basel II regulation in the crunch that succeeded its announcement, in contrast to Basel I. We demonstrate that these dynamics are governed by a formula linking the two ratios together which derives from the sensitivity of the risk-based capital ratio to a change in its risk-weight(s). One implication of our work regarding the Basel III regulation consists in validating the newly established capital increments in a mathematical rather than heuristical approach

How did deposit interest rate ceilings, an important feature of the U.S. regulatory regime until the mid-1980s, affect individual banks’ lending and the transmission of monetary policy to credit? I estimate the effect of deposit rate ceilings inscribed in Regulation Q on commercial banks’ credit growth using a historical bank level data set starting in 1959. Banks’ credit growth contracted sharply when legally fixed deposit rate ceilings were binding. Interaction terms with monetary policy suggest that the policy impact on bank level credit growth was non-linear and significantly larger when rate ceilings were in place. Bank size and capitalization mitigate these effects. At the bank level, short-term interest rates exceeding the legally fixed deposit rate ceilings identify policy induced credit supply shifts that disappeared with deposit rate deregulation and thus weakened the bank lending channel substantially since the early 1980s

We develop a theory of optimal bank leverage in which the benefit of debt in inducing loan monitoring is balanced against the benefit of equity in attenuating risk shifting. However, faced with socially costly correlated bank failures, regulators bail out creditors. Anticipation of this generates multiple equilibria, including one with systemic risk in which banks use excessive leverage to fund correlated, inefficiently risky loans. Limiting leverage and resolving both moral hazards—insufficient loan monitoring and asset substitution—requires a novel two-tiered capital requirement, including a “special capital account” that is unavailable to creditors upon failure