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Market risk-based capital requirements, trading activity, and bank risk

Dmytro Holod, Yuriy Kitsul and Gökhan Torna

Journal of Banking & Finance, 2020, vol. 112, issue C

Abstract: This study investigates if market risk-based capital requirements (MRR) implemented in 1998 mitigated bank risk associated with trading activities. Recognizing that only banks with sufficiently high trading activities are subject to the MRR (regulated), we implement a difference-in-difference (DID) approach to show that in the post-MRR period, unregulated banks experienced an increase in risk associated with trading activity, while their regulated counterparts enjoyed no appreciable change in trading-related risk. We interpret the resulting negative DID coefficient as the evidence of a risk-mitigating effect of the MRR. This effect disappears at already well-capitalized banks. We also show that upon the implementation of the MRR, unregulated banks exhibit a significantly larger increase in contribution of opaque trading activity to bid-ask spreads, compared to regulated banks, for which the association between trading activity and bid-ask spreads actually declines. Our results are consistent with the view that the MRR significantly reduced moral hazard and adverse selection problems associated with opaque trading activities.

Keywords: Market risk-based capital requirements; Capital regulations; Trading activity; Systematic risk; Idiosyncratic risk; Information environment (search for similar items in EconPapers)
JEL-codes: G00 G20 G21 G28 (search for similar items in EconPapers)
Date: 2020
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DOI: 10.1016/j.jbankfin.2017.08.019

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