This paper investigates how the regulation of bank wealth management products (WMPs) affects corporate innovation. We build a concise model linking firms’ assets allocation decisions to regulatory variables affecting banks. The model suggests that current WMP regulation can enhance formal lending and stimulate innovation among state-owned enterprises (SOEs), while having no impact on innovation in private enterprises (PEs). Empirically, we identify firms’ exposure to bank regulation by examining the number of WMPs issued by banks in 2017 and the distance between banks and firms. Our results indicate that innovation output significantly increased for highly exposed SOEs, while there was no significant change for PEs. Using city-level data, we further observe that regulation fosters innovation in regions with higher exposure. Our findings suggest that regulation exerts heterogeneous effects on the real economy by banks’ credit allocation and firms’ investment strategies

This paper analyzes the effects of bank capital regulation on the link between bank size and volatility. Using bank-level data for 27 advanced economies over the 2000–2014 period, we estimate a power law that relates the volume of a bank’s loan portfolio to the volatility of loan growth. Our analysis reveals, first, that more stringent capital regulation weakens the size-volatility nexus. Hence, in countries with more stringent capital regulation, large banks show, ceteris paribus, lower loan portfolio volatility. Second, the effect of tighter capital requirements on the size-volatility nexus becomes stronger for the upper tail of the bank size distribution. This is in line with capitalization decreasing with bank size, such that larger banks tend to be more affected by increasing capital requirements. Third, in countries with higher sectoral capital buffers, the size-volatility nexus is weaker

We analyze the limits of regulating bank CEO compensation to reduce risk shifting in the presence of an active board that retains the right to approve new investment strategies. Compensation regulation prevents overinvestment in strategies that increase risk, but it is ineffective in preventing underinvestment in strategies that reduce risk. The regulator optimally combines compensation and capital regulations. In contrast, if the board delegates the choice of strategy to the CEO, compensation regulation is sufficient to prevent both types of risk shifting. Compensation regulation increases shareholders’ incentives to implement an active board, which reduces the effectiveness of compensation regulation

We present a screening model of the risk sensitivity of bank capital regulation. A banker funds a project with uninsured deposits and costly capital. Capital resolves a moral hazard problem in the choice of the probability of default (PD). The project’s loss given default (LGD) is the banker’s private information. The regulator receives a noisy signal about the LGD and imposes a minimum capital requirement. We show that the optimal sensitivity of capital regulation is non-monotonic in the accuracy of risk assessment. If the signal is inaccurate, the regulator should use risk-insensitive capital requirements. Given sufficient accuracy, the regulator should separate types via risk-sensitive capital requirements, reducing the risk-sensitivity of bank capital as accuracy improves

This paper is based on a panel discussion at the international bank conference on Frontier Risks, Financial Innovation and Prudential Regulation of Banks in Gothenburg, Sweden, June 2–4, 2024. The panelists were Deborah Lucas, Jan Pieter Krahnen, and Magnus Olsson, with Ted Lindblom moderating. This paper contains the panel presentations, along with a unifying discussion by Paolo Fulghieri and Anjan Thakor. The main themes in the paper focus on how society should balance costs and benefits in designing the prudential regulation of banks. Optimal regulation should take into account how banks and markets interact, the dangers of both under-regulation that spawns excessive risk-taking and over-regulation that depresses value-enhancing innovation in financial services, the somewhat fragmented nature of national-sovereignty-constrained European banking and financial markets regulation relative to bank regulation in the US, and how prudential regulation can be improved by more explicitly dealing with interest rate risk

We examine the impact of foreign bank presence on a host countries’ business regulatory environment. We employ a panel dataset of 87 developing economies for the 1995–2013 period and measure the efficiency of business regulations using the indices from the Heritage and the Fraser datasets. Our results show that foreign bank presence exerts a positive impact on the efficiency of business regulations; however, we find no evidence in favor of a more pronounced positive effect when foreign banks originate from countries that have a more efficient business regulatory environment. Moreover, host countries’ administrative requirements and, particularly, bureaucracy costs benefit from a foreign bank presence; however, cost and time procedures to start a business do not

This paper investigates whether inclusive banking can boost bank-level performance, using an international sample of 1,740 banks over the period 2004-2015. We find that there is a significant positive association between financial inclusion and bank efficiency. Greater financial inclusion helps banks in reducing the volatility of their deposit-funding share as it provides more stable long-term funds for banks, while also mitigating the adverse effects of their return volatility. The association is stronger in countries with limited restrictions on banking activities or more capital regulation stringency as the deposit channel enables greater flow of low-cost funds for high-return investments. The results are robust to instrumental variable analysis, multiple dimensions of financial inclusion (supply, demand, and pro-access policy), and a difference-in-differences estimator that exploits cross-country and temporal variations in actively promoting an inclusive agenda, further confirming that inclusive financial development can be beneficial for banks

Existing regulatory capital requirements are often criticized for only being loosely linked to the economic risk of the banks' assets. In view of the attempts of international regulators to introduce more risk sensitive capital requirements, we theoretically examine the effect of specific regulatory capital requirements on the risk-taking behavior of banks. More precisely, we develop a continuous time framework where the banks' choice of asset risk is endogenously determined. We compare regulation based on the Basel I building block approach to value-at-risk or ‘internal model’-based capital requirements with respect to risk taking behavior, deposit insurance liability, and shareholder value. The main findings are: (i) value-at-risk-based capital regulation creates a stronger incentive to reduce asset risk when banks are solvent, (ii) solvent banks that reduce their asset risk reduce the current value of the deposit insurance liability significantly, (iii) under value-at-risk regulation the risk reduction behavior of banks is less sensitive to changes in their investment opportunity set, and (iv) banks' equityholders can benefit from risk-based capital requirements

We study the economic consequences of mandates that require bank auditors to report to bank regulators. Based on survey responses from the European Central Bank, all 28 national bank regulators within the European Union, and a review of national banking regulations, we create a novel dataset on these mandates. Exploiting the cross-sectional and time-series variation in these mandates, we find evidence that auditor reporting to bank regulators reduces bank riskiness, as measured by counterparty risk and credit spreads. We also observe a decline in problem loans and risk-weighted assets, as well as improvements in timeliness of loan loss provisions. Additional analyses suggest that mandated auditor reporting increases the effectiveness of supervisory and monitoring efforts and improves market discipline of banks. However, mandated auditor reporting comes with costs: it reduces future lending growth, risky lending, and profitability, and increases audit fees paid by shareholders

We measure market reactions to announcements concerning liquidity regulation, a key innovation in the Basel framework. Our initial results show that liquidity regulation attracts negative abnormal returns. However, the price responses are less pronounced when coinciding announcements concerning capital regulation are backed out, suggesting that markets do not consider liquidity regulation to be binding. Bank- and country-specific characteristics also matter. Liquid balance sheets and high charter values increase abnormal returns whereas smaller long-term funding mismatches reduce abnormal returns. Banks located in countries with large government debt and tight interbank conditions or with prior domestic liquidity regulation display lower abnormal returns