Risk taking by banks has been discussed extensively by researchers and policy makers for many years, even preceding the Great Recession. Literature has focused on two mechanisms that alter banks’ risk-taking behavior: higher regulatory capital ratios and higher competition due to bank deregulation. But, how does a bank’s equity capital ratio interact with banking competition in their impact on risk taking? In a forthcoming RCFS paper, “Effect of the Equity Capital Ratio on the Relationship between Competition and Bank Risk-Taking Behavior,” Jia Hao and Kuncheng Zheng explore the answer to this important question and provide interesting findings. While competition in the banking market mitigates banks’ risk-taking behavior on average, banks’ ex- ante equity capital ratio can alter this relationship. Authors show that increased competition leads to relatively larger reductions in risk taking–especially in their lending portfolios–only by banks with low ex-ante equity capital ratios. This difference between high- and low-capital banks in risk-taking behavior cannot be explained by pre-existing trends, geographical location, or other bank characteristics, such as size, that may influence bank risk-taking. Overall, this paper shows us that a bank’s capital ratio has not only a direct effect but also an indirect effect on its risk taking. Therefore, this indirect effect should be considered in using capital requirements to mitigate risk taking by banks.
Spotlight by Isil Erel
Photos courtesy of Jia Hao and Kuncheng Zheng