Do well-capitalised banks take more risk? Evidence from the Korean banking system

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Papers Do well-capitalised banks take more risk? Evidence from the Korean banking system Thomas D. Jeitschko and Shin Dong Jeung 

Department of Economics, Michigan State University, East Lansing, MI 48824-2127, USA tel: þ 1 517 355 8302; fax: þ 1 517 432 1064; e-mail: [email protected]

Thomas D. Jeitschko is Professor of Finance at Royal Holloway College, University of London, and Associate Professor of Economics at Michigan State University in East Lansing, Michigan. He holds additional appointments as adjunct Professor of Finance in the Finance Department and as adjunct Professor of Law in the Law School at Michigan State University. He specialises in economic theory and information economics with applications across several fields, including financial intermediation, banking, and law. He has published his research in the American Economic Review, Games and Economic Behavior, Economic Theory, and the Journal of Banking and Finance, among other places.

regulatory policies. This empirical study incorporates the incentives of the three entities that influence the risk determination of a bank, namely regulatory agencies, shareholders, and management. The test results using data from the Korean banking system show measurable differences in risk–capitalisation relationships across banks differentiated by the level of capitalisation, and across publicly- and nonpublicly traded banks. These results provide evidence that risk–capitalisation relationships are sensitive to the relative forces of the three sources of influence in determining asset risk — which may account for previous inconclusive findings.

Shin Dong Jeung is the Head of the Early Warning Team in the Macro-Supervision Department of the Financial Supervisory Service — the Korean Banking Regulatory Agency — in Seoul. He holds a PhD in economics from Michigan State University and has previously worked for the Bank of Korea (the central bank of Korea). He specialises in risk-taking behaviour in banking and has carried out theoretical and empirical work across several countries, including the United States and South Korea. He has previously published in the Journal of Banking and Finance.

INTRODUCTION The relationship between banks’ capitalisations and risk-taking behaviours is one of the central issues in the banking literature because of the potential implications for regulatory policies. The minimum capital requirement — which currently constitutes the core regulatory instrument for the banking industry — is based on the premise that increased capital enhances bank safety. As discussed in Jeitschko and Jeung,1 however, this premise may not hold under some relevant circumstances. Indeed, if increased capital induces a bank to increase asset risk (the so-called asset substitution effect of capital), and this effect supersedes the buffer effect of capital (ie larger capital absorbs more risk), then it is possible that a more highly

ABSTRACT

The relationship between banks’ capitalisations and risk-taking behaviours has important implications for

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