The effectiveness of risk-based supervision in the adjustments of capital buffer and portfolio risk: An empirical study of Thai commercial banks

Abstract

As a means to economic growth and development, banking is one of the most heavily regulated industries due to externalities from banking failures. Banking regulation aims to maintain safety and soundness in order to protect depositors' losses, which may result from insolvency and/or illiquidity. Banking crises have induced policy makers to place emphasis on protective regulatory policy. Therefore, banking policy focuses on the regulation of capital, which is a centerpiece of the government intervention because it can affect risk-taking by bank owners and constitutes a buffer to absorb unexpected losses. The financial microeconomic literature places its interest the relationship between regulatory capital requirements and bank capital and risk taking. Banking examinations are another form of prudential supervision that directly limit and control moral hazard incentives for excessive risk taking.

This study explicates the interrelations among the public policy process, bank regulations, and financial economics. This study evaluates the effectiveness and impact of banking supervision and examination on banks' moral hazard behaviors. It focuses on the relationship between banking examinations and bank capital and risk taking. In addition, the study extends the investigation to the relationship between banks' franchise value and capital and risk behaviors. The study also discusses and tests the capital buffer theory. The empirical estimations employ panel data from Thai commercial banks' financial statements during the ·period of 2002Q 1 to 2008Q3 and model specifications, which are developed from Shrieves and Dahl's (1992) simultaneous equations with a partial adjustment framework in order to investigate the relationships theoretical proponents. The empirical analyses experiment with the Instrumental Variable (IV); namely, Three-Stage Least Squares (3SLS) and Generalized Method of Moments (GMM), and Full Information Maximum Likelihood (FIML).

The results of the estimates construe public policy in terms of its evaluation: that risk-based examination is effective in mitigating risk in Thai commercial banks. The negative relationship between changes in capital and portfolio risk is statically significant. Similarly, the results of the estimates indicate a negative relationship between changes in capital buffer and portfolio risk. This study finds that prudential supervision is effective in mitigating risk in Thai commercial banks; however, the capital directive has unintended effects on the changes in the banks' capital and their buffer. This study also finds that the franchise value determines the banks' portfolio risk but not changes in either the capital or capital buffer. The study presents several implications for banking examination development, such as the maroprudential and microprudential implications on countercyclical supervision, and stress testing, which are in line with international standards of Basel Committee in Banking Supervision (BCBS), Bank for International Settlements (BIS).