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Charles A. Dice Center for Research in Financial Economics
The Effects of Risk-based Capital on Wealth and Risk-taking in Banking
ABSTRACT
I examine whether risk-based capital requirements caused changes in risk and wealth among U.S. banks. I find that banks with the lowest asset quality prior to the new regulation experienced relative improvement in quality in the post-regulatory period while asset quality deteriorated for banks with high quality assets. Furthermore, risk as measured by the variance of stock returns and residual variance increased immediately after the initial risk-based capital announcement. Surprisingly, across banks the change in risk does not decrease with bank charter values but decreases with loan quality. Finally, interest rate gap increased after risk-based capital was implemented. In the analysis of wealth effects, I find that risk-based capital standards were costly for U.S. banks. The new capital standards produced statistically and economically significant negative abnormal returns to shareholders of banks with the highest holdings of assets that were classified as "high risk" in the Accord. Moreover, the new standards may have unfairly penalized banks that made "good" commercial and consumer loans. Thus, risk-based capital standards appear to tax investment in assets classified as high risk without regard to the actual quality of assets within types. Additional evidence of the costliness of these standards is that upon passage of the Basle Accord there was a significant increase in the relative price of bank loans versus other short-term borrowing. I conclude that while risk-based capital was costly for banks, it did not lead to a reduction in risk by all banks.
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