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Capital Regulation Paradox and Market Discipline of Bank Regulation

Author: JiangZuo
Tutor: PengShouKang
School: Zhejiang Technology and Business University
Course: Finance
Keywords: capital regulation paradox market discipline bank’s riskbehavior contingent convertible bond
CLC: F831.2
Type: Master's thesis
Year: 2013
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Abstract


Market discipline is one of the three pillars that new basel capital accord uses to regulate bank’s risk behavior. Before the global financial crisis, subordinated debt has long been regarded as a kind of financial instruments that can effectively strengthen bank’s market discipline. But from the outburst of the financial crisis, subordinated debt does not play its due role of market discipline.Perfect bank regulation should include minimum capital requirement, supervisory review and market discipline, but basel committee has long been too much emphasis on the minimum capital requirement regulation and ignored the importance of market discipline. Based on the background of the outbreak of the global financial crisis, due to the special capital structure of bank, this paper obtains the necessity of minimum capital requirement regulation. Then, it comes to the conclusion that entirely depending on the minimum capital requirement regulation cann’t effectively constrain bank’s risk behavior because of the existence of bank capital regulation paradox:on the one hand, bank is easy to fall into the survival crisis when it suffers from a large shock because bank has high asset-liability ratio, so bank needs to increase capital adequacy ratio substantially to reduce the occurring possibility of bank such risk; on the other hand, the cost of equity is expensive, to increase bank’s minimum capital requirement, especially bank’s equity capital requirement, which will reduce bank’s franchise value, therefore intensifying the bank’s moral hazard. So far, there is still no model about capital regulation paradox. In order to confirm the existence of bank capital regulation paradox, this paper builds a mathematical model which indicates that bank shareholders’expected return presents positive correlation with bank’s risk, negative correlation with the minimum capital requirement, further proofing the existence of bank capital regulation paradox. Therefore, bank’s risk behavior needs to strengthen market discipline. Because the existence of deposit insurance system and government recessive guarantee, current financial tools, for example, subordinated debt, can’t meet the need of the market discipline supervision, so bank’s regulation is not perfect. In order to fully arouse the regulatory motivation of bank stakeholders, improving bank’s regulation, this paper introduces an innovative financial instrument—— contingent convertible bond, which is different with subordinated debt and convertible bond. Currently, due to the study on contingent convertible bond is in its infancy, so this paper spreads a detail discussion on this bond, and researches its market discipline on bank’s risk behavior with theory and model. In theory, contingent convertible bond can effectively inspire bank’s stakeholder to regulate bank’s risk behavior, so this bond can effectively strengthen bank’s market discipline. Because current model analyses about contingent convertible bond generally focus on the design of conversion trigger and conversion rate, and almost not exist a model research about market discipline of contingent convertible bond. In order to discuss market discipline of contingent convertible bond more fully, this paper builds another model which indicates that expected return of bank original shareholders reaches maximum when bank’s risk is in its minimum statement after bank issuing contingent convertible bond, supporting the motivation of bank’s stakeholders to regulate banks’ risk. In conclusion, contingent convertible bond can strengthen bank’s market discipline, constraining bank’s risk behavior effectively, therefore improving bank’s regulation.

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CLC: > Economic > Fiscal, monetary > Finance, banking > World of finance, banking > Financial organizations and business
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