Bank Equity Capital and Risk-taking Behavior: The Effect of Competition

Research Interest
Recent proposals to improve financial stability by increasing the minimum capital requirement rely on the assumption that a high equity ratio mitigates risk-taking. However, there is little evidence on how this relationship changes in the presence of other risk-mitigating devices, such as increased competition in the banking market. We show that competition can not only be an alternative mechanism to mitigate risk-taking, but also impacts the relationship between bank capital ratios and risk-taking. More specifically, when facing increased competition, low-capital banks engage in relatively larger reductions in risk-taking. They do so primarily by decreasing the risk in their lending portfolios. This empirical finding suggests that the competitive landscape in the banking sector should be taken into account when considering changes in capital requirements.