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Taking Firms and Markets Seriously: A
Study on Bank Behavior, Market
Discipline, and Regulatory Policy
Thomas Bernauer and Vally Koubi
Objectives
 Accounting systematically for the behavior of firms
and markets is important for understanding
regulatory policy, particularly in the economic realm.
We examine the US banking sector and its regulation
in the 1990s to gain insights on how studies along
these lines could be constructed.
 Examine whether market discipline could fully
substitute for governmental regulation of banks’
minimum capital requirements => empirical puzzle of
overcompliance
 Examine complementarities among markets and
regulation
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Average Capital-Asset-Ratios of
Banking Sectors in Selected
G-10 Countries
20,00
18,00
observed CAR rati os (US average)
Tier 1 CAR Average
16,00
Tier 1 + Tier 2 CAR Average
14,00
Average Capital-Asset Ratios
in the U.S. Banking Sector
12,00
10,00
regulatory requirement for Tier 1 + T ier 2 CAR
8,00
6,00
regulatory requirement for Tier 1 CAR
4,00
2,00
0,00
1990
Datum
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
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Bank Capital

It is a direct source of funds for loans.

It affects the perceived riskiness of bank deposits.

Banks with higher capital-asset ratios are perceived as safer
managers of borrowed funds and are able to attract deposits at
more favorable terms (lower rates) than low capital-asset ratio
banks.

A bank then can use its capital ratio as a means of establishing a
cost advantage against its competitors (substitution effect).

A highly capitalized banking industry makes bank deposits relatively
safer in comparison to other investments (from the investordepositor’s point of view) benefiting all banks (the general effect: an
externality)
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Theoretical Model
 A bank may manipulate its capital-asset ratio (CAR) to
influence its borrowing costs. This behavior has
implications for bank capitalization and hence for the
necessity - and form - of bank regulation.
 The relationship between borrowing costs and CAR is
R = R(k, k*)
R = interest rate on borrowing funds
K = own bank capital
k* = average capital of entire banking system
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 If bank creditors (depositors) care about individual bank risk
(bankruptcy) then
dR
0
dk
 If bank creditors care about bank systemic risk then
dR
0
dk *|d ( k k *)0
 Depositors may care about both idiosyncratic and systemic
bank risk. Which one do they care about more? The answer
depends on the sign of
dR
dk * |dk 0
?
This sign determines whether the banking system is undercapitalized or not.
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CASE A
dR
0
dk * |dk 0
Free riding
An unregulated banking sector is undercapitalized.
CASE B
dR
0
dk * |dk 0
No free riding
Market forces work against undercapitalization
We show that, in the absence of deposit insurance, banks are
not undercapitalized.
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Empirical Analysis
Does competition make banks care about CAR?
Rit = w1*kit + w3*xit + uit
H: w1 < 0
Data: yearly observations on the entire population of US banks in the
period 1990-2000 (approximately 130,000 bank-years).
Method: pooled cross-section times series regressions with a fixed effects
procedure.
Rit = average cost of deposits = ratio of deposit interest expense to value
of total deposits
kit = tier 1 capital-asset ratio (tier 1 capital divided by total risk weighted
assets)
xit = bank size and idiosyncratic characteristics (number of employees,
total value of assets, return on equity, non-performing loans)
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 Well-capitalized banks face lower average interest
expenses on their deposits (ki).
 While additional capital lowers borrowing costs, it does so
at a decreasing rate (ki2).
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 Well-capitalized banks face lower average interest
expenses on their deposits (ki) at a decreasing rate (ki2).
Competition among banks should contribute to higher levels
of bank capitalization.
 Large banks – either in terms of number of employees
(EMPL), or value of assets (ASSET) – face lower borrowing
costs, and so do banks that are more successful in terms of
higher returns on equity (ROE).
 Banks with a larger share of non-performing loans (NONP)
face higher interest expense ratios.
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If banks care about CAR, do they care enough to make them
eliminate the free riding problem?
Rit = w1 (kit –k*) + w2 kt* + w3 xit + uit
w1 < 0 (competition effect)
w2 < 0 free riding
w2 > 0 no free riding
kt* is the average capital-asset ratio at time t in the US state
where the bank is located.
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 Both w1 and w2 (the coefficients for the variables ki - k* and
k*) are statistically significant and negative)

if a bank increases its capital-asset ratio relative to the U.S. state
average, it reduces its borrowing costs;

an increase in the industry-wide capital-asset ratio also reduces the
bank’s borrowing costs.
 Yet, given that the coefficient for the average capital-asset
ratio, k*, is much larger than that for the individual capitalasset ratio (ki –k*), the latter effect dominates.
 Competition among banks is not sufficient to eliminate the
free-rider problem.
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Conclusions
 In the US, better capitalized banks indeed face lower borrowing costs.
 Bank competition could not have perfectly substituted for capital
adequacy regulation because of substantial systemic effects (free
riding).
 The main value of some bank regulations, such as parts of the Basle
Accord, may be found in their ability to strengthen bank competition by
generating simple benchmarks for comparing the riskiness of banks.
 Policy Implications: an integral - if not the key - part of domestic and
international regulatory efforts should involve transparency-creating
regulation. International standards of this type can encourage economic
actors in various countries to signal superior quality to their respective
markets by complying or even over-complying with environmental,
corporate governance, accounting, or other standards.
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