The Dynamics of Capital Regulation and U.S. Banks’ Risk-Taking

We outline a variety of hypotheses regarding bank risk-taking behavior in a transition period prior to the implementation of new more stringent capital adequacy and business line restrictions. In one view, developed in the paper, there is an incentive for increased risk-taking in the transition period despite the naïve hypothesis that banks will act as regulators intend for a future period. Important factors include the maturity of assets in the business line, the costs of adjustment, and the nature of the uncertainty about characteristics of the impending regulations. We examine empirical evidence to determine which hypotheses on risk shifting are observable in the run-up to implementation of Dodd-Frank and related rules. We find evidence of differential risk-taking driven by future more stringent capital regulation, some TBTF effects, and a role for TARP and other various characteristics of the banks in the pre-transition period. Naïve hypotheses of compliance, the null hypothesis of no shifts, and Regression to the Mean are rejected