By Stephanie M. Stolz
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Extra info for Bank Capital and Risk-Taking [electronic resource]: The Impact of Capital Regulation, Charter Value, and the Business Cycle
In addition, I include dummy variables in the capital and risk equation. First, the savings banking sector has seen a merger wave in the last years. When a savings bank faces financial troubles, it is merged with a healthy bank in the neighborhood. I therefore expect to observe a decrease in capital and an increase in risk for the takeover bank in the year of the merger. 2 The Empirical Model 41 effects, I include a merger dummy variable, dyMERGER, in the regression equations which is unity in the year a savings bank takes over another bank and zero otherwise.
6 Hypotheses on ... 29 centive to hold a capital buffer. In this sense, charter value has a disciplining effect on banks' risk-taking. However, the effect of banks' charter value on banks' capital buffer is nonlinear: for banks with high charter values, the optimum capital buffer increases, as the charter value decreases (see Figure 2). Only if the charter value falls close to the fixed cost of recapitalization is the relationship reversed. The problem with testing this nonlinearity is that banks' cost of recapitalization is not observable.
With such a trade-off, the following adjustment is predicted: an increase in the capital requirement decreases banks' capital buffers, thereby increasing their risk aversion. If banks cannot adjust risk instantaneously, banks stretch the necessary decrease in asset risk over several periods. At the same time, banks rebuild capital towards optimum capital levels. The increase in capital decreases banks' risk aversion and, thus, increases optimum risk levels. As soon as actual asset risk and desired asset risk are equal again, the bank again increases both capital and risk until it reaches the optimum capital level.