Direct and indirect impacts of European banks’ regulation

This paper examines whether bank regulation and supervision have independent effects on the capital buffer and insolvency risk or their effects are channelled through the business cycle and income diversification. The findings show that regulatory capital index and supervisor power index have both the direct effect on bank capital buffer as well as bank risk and indirect effects via business cycle, whereas restriction on bank activities indirectly channels its effects through income diversification. Economic downturn with tighter capital regulation diminishes the benefit of the capital buffer. The restriction on bank activities policy is not effective for EU banks that highly involve in risk-taking activities. Increasing official supervision related to the change in the business cycle only brings benefit to capital buffer but harms banks' stability. Regulators should adjust capital regulation on the business cycle, introduce the tighter restriction on bank activities and an appropriate supervision control to reduce bank risk-taking behaviour.