Evaluating the Effects of Post-Crisis Capital Regulation on the Riskiness of the Banking Sector

Abstract

This paper studies the riskiness of the banking sector after increased capital regulations set by the Basel III framework and the Dodd Frank rules. I find that bank debt has become riskier despite increased capital, consistent with Sarin and Summers (2016), but idiosyncratic bank equity risk has decreased with increased capital. This result is counterintuitive as the intention of capital regulation is to decrease solvency risk. I explore possible explanations for the increase of risk for bondholders and find that increased bank debt risk can be partially explained by a decrease in franchise value and to a lesser extent, the low rate environment and the changes in the portfolio of assets held. I propose two explanations for why the risk of bank debt has increased: First, as supported by my results, price-to-book and the leverage ratio, measured using market value of equity, decreased after the crisis. The decline in this leverage ratio puts the debt holders in a riskier position. Second, under the new resolution-planning framework, the Orderly Liquidation Authority allows the FDIC rather than the bankruptcy court to determine priority claims in the event of bankruptcy. This new uncertainty faced by bondholders has also increased bank debt risk.