The impact of capital regulation, income diversification and ownership structure on risk of commercial banks

Abstract

The 2007-2008 financial crisis provides evidence of acceleration of bank risk due to the absence of adequate capital level. To address the excessive risk-taking and default of the bank, regulatory authorities emphasise the capital adequacy regulation. This study examines the effect of capital adequacy regulation on the risk of the banking system of different economies. Moreover, the effect of income diversification, ownership structure and concentration risk are examined on the risk of the bank. 565 commercial banks from 52 countries were studied during the period from 2011 to 2015. Considering the panel nature of this study, linear dynamic panel data model estimation using the Maximum Likelihood with Structural Equation Modelling was followed. The result is consistent with the existing empirical evidence that finds the increase of capital ratio decreases bank risk and the regulatory pressure affects the risk of the bank negatively. Also, the study finds income diversification through engagement in non-traditional activities decreases the risk and increases the liquidity and solvency of the bank. Also, the concentration of ownership is negatively associated with the liquidity risk of the bank. Finally, the study finds that although the negative effect of regulatory pressure causes banks to increase their risk undertaking, in the long-term, they increase the capital level followed by a decrease of default risk of the bank. The study helps fill the gap in banking literature on the effect of recent changes in the capital regulation on bank risk in different economies and reaffirms the crucial role of increasing the non-traditional activities to diversify their income sources with an aim to increase the solvency.