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Market Discipline Working for and Against Financial Stability: The Two Faces of Equity Capital in U.S. Commercial Banking

Listed author(s):
  • Joseph P. Hughes

    ()

    (Rutgers University)

  • Loretta J. Mester

    ()

    (Federal Reserve Bank of Cleveland and the Wharton School, University of Pennsylvania)

  • Choon-Geol Moon

    ()

    (Hanyang University)

The second Basel Capital Accord points to market discipline as a tool to reinforce capital standards and supervision in promoting bank safety and soundness. The Bank for International Settlements contends that market discipline imposes strong incentives on banks to operate in a safe and efficient manner – in particular, to maintain an adequate capital base to absorb potential losses from their risk exposures. Using 2007 and 2013 data on top-tier, publicly traded U.S. bank holding companies, we find that market discipline rewards risk-taking at some of the largest U.S. financial institutions. In particular, we find evidence of two faces of equity investment – dichotomous capital strategies for maximizing value. At banks with higher-valued investment opportunities, a marginal increase in their equity capital ratio is associated with better financial performance, while at banks with lower-valued investment opportunities, a marginal decrease in their equity capital ratio is associated with better financial performance. Because the largest U.S. financial institutions tend to have lower-valued investment opportunities, our results suggest that they may have a market-based incentive to reduce their capital ratio. To the extent that market discipline rewards reducing the capital ratio among the largest banks, it would tend to undermine financial stability. Our results support the need for regulatory capital requirements.

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File URL: http://www.sas.rutgers.edu/virtual/snde/wp/2016-11.pdf
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Paper provided by Rutgers University, Department of Economics in its series Departmental Working Papers with number 201611.

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Length: 38 pages
Date of creation: 14 Dec 2016
Handle: RePEc:rut:rutres:201611
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  2. Hughes, Joseph P. & Mester, Loretta J. & Moon, Choon-Geol, 2001. "Are scale economies in banking elusive or illusive?: Evidence obtained by incorporating capital structure and risk-taking into models of bank production," Journal of Banking & Finance, Elsevier, vol. 25(12), pages 2169-2208, December.
  3. Hughes, Joseph P. & Mester, Loretta J., 2013. "Who said large banks don’t experience scale economies? Evidence from a risk-return-driven cost function," Journal of Financial Intermediation, Elsevier, vol. 22(4), pages 559-585.
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