Essays on Bank Prudential Regulations

Abstract

This paper theoretically and empirically analyzes the relationship between deposit competition, model-based capital requirements (BaselAccords) and bank risk-taking. I first build a model where banks are subject to capital requirements in which there are arbitrage opportunities in an internal rating based (IRB) approach introduced in Basel II/III, depositors have preference on banks due to transaction cost, and the regulator conducts supervisory check on bank capital adequacy. The model shows two sets of results: first, given a certain level of deposit competition and as the capital requirements are evolved, the effectiveness of the requirements on reducing bank risk-taking improves when supervisory power is high enough to restrict bank arbitrage in IRB approach; second, the non-risk based leverage ratio in Basel III, when binding, can simultaneously reduce bank risk-taking and lower required supervisory power that restricts bank arbitrage. However, the binding ratio can potentially distort some banks' incentives to invest prudently. I then externally validate some testable implications drawn from the theory with System GMM and Difference-in-Difference using a large panel dataset for U.S. commercial banks. I find that the introduction of IRB approach reduces bank ex ante credit risk, suggesting the potential regulatory capital arbitrage. I also find that lower deposit competition and stricter capital requirements reduce bank credit risk. All empirical findings are consistent with the theory. Keywords: Capital Requirements, Internal-Rating Based Approach, Leverage Ratio, Competition, Supervision. JEL classification: G21, G28.