Assessing intertemporal effects of regulation on bank risk: An international perspective

Objective: To test whether bank choices of business lines during the transition to more stringent but uncertain capital requirements could be contrary to the intentions of the regulators regarding bank risk. We apply a theoretical model to an empirical analysis of behavior of various classes of banks across different regulatory jurisdictions.

Approach: We will compare US banks that are designated as systemically important (>$50 billion) and internationally-active with 1) other US smaller banks (>$10b) that were not subject to Basel II and 2) with Swiss banks similarly operating under Basel II Advanced approach. We also compare those six Swiss banks to twenty other Swiss banking firms. We exploit different timing and approaches by Swiss, US, and European regulators to test the role of uncertainty. The tests focus on a difference of differences between countries and within countries.

We verify that changes in relative return volatility are observable and then use variables based on existing literature and theory to identify drivers related to changes in business lines and risk. The variables will include capital ratios, types of liabilities and assets, and control variables for local economic activity. In addition, we incorporate uncertainty measures and measures of adjustment costs.

From mid-2009 to passage of Dodd-Frank in 2010 was a period of relatively high uncertainty for “SIFI” and TBTF banks in both the US and Switzerland. The period from the Swiss statement of requirements for their TBTF banks to the end of 2011 when new Basel rules were promulgated is a second less uncertain period followed by a period of greater certainty. The different treatment of Swiss investment banking activities also will play an important role in defining uncertainty. We will control for national economic factors and use a control group of EU banks that only faced Basel uncertainty after 2009.

Expected Results: We hypothesize that, in transition periods, higher risk can be attributed to risk-taking incentives and to uncertainty about the future rules. Riskier business lines that can be unwound quickly are more likely to remain or be expanded during the transition periods (contributing to more risk) than are activities that require a longer term investment, that are subject to future capital charges, and that would be difficult to sell later. We hypothesize that uncertainty in the US was larger than in Switzerland pre-2012 and thus that the observed relationships are stronger in the US.