0 Capital Constraints and Systemic Risk

The amendment of the Basel Accord with the market-risk-based capital requirements, introduced in 1996 and officially implemented in the U.S. in 1998, can be considered as a an exogenous shock to desired (adequate) capital of banking organizations, which could make a balance-sheet amplification mechanism more pronounced due to an additional balance sheet constraint. We study how sensitivity of bank equity returns to common factors, or bank systematic risk, has changed once this new regulation had been introduced. In particular, we focus on the systematic risk gap between high and low trading banks, since only banks with sufficiently high trading activities are subject to the additional capital charge, while distinguishing between low and high capital banks to approximate for how close a bank is to hitting its capital constraint. In the panel data of quarterly stock returns for large publicly traded bank holding companies, we find that, after controlling for a number of bank characteristics, a contribution of a bank’s trading activity to its systematic risk becomes stronger after 1998, a period when new regulation was in place, but this increase is stronger for low capital banks. Our results, although consistent with the current capital regulation’s intent to provide more protection against losses via a capital cushion, also point to a potential for an unintended systemic side effect of the regulation. These findings may be relevant for the future regulatory design