Bank risk-taking, regulations and market discipline : three essays

In the first chapter, I analyze how early corrective actions affect bank risk taking and welfare of agents in an economy. Early corrective actions considered in this paper are classified into two categories: early closure and (early) recapitalization. It is shown that early closure might be preferable to save government expenses (explicit costs), but it causes inefficient bank risk-taking (implicit costs). It is not obvious whether the resolution costs and inefficiency in bank risk taking are smaller under recapitalization. However, there is a type of recapitalization in which not only does the government incur no resolution costs, but also recapitalization might reduce inefficiency. This type of recapitalization gives better ex ante expected returns so that there is Pareto improvement. The second chapter examines market discipline in the Korean banking system. Evidence of strong market discipline is essential to justify the cession of government regulatory control to the market. Two types of markets are tested: (i) the market for uninsured liabilities, and (ii) the market for bank equity. I find week evidence of market discipline in the market for uninsured liabilities in Korea. In the case of the market for bank equity, no evidence of market discipline is found. Overall, the estimation results in the two markets do not provide strong evidence of market discipline in the Korean banking system during the sample periods. In the third chapter, I examine the relationship between bank size, diversification and risk in Korean banks. Recent mergers in the Korean banking industry show that the government encourages and supports banking consolidation in various ways as a part of restructuring the financial sector. This policy trend is based on the presumptions that bigger banks are better diversified than smaller banks, and that diversification can potentially reduce the probability of failure. I test this conventional wisdom. The estimation results provide strong evidence of the positive relationship between bank size and diversification; bigger banks are better diversified than small banks. However, the results show that bigger banks’ diversification, at least in bank loans, does not generate enhanced safety in Korean banks. This suggests the possibility of the “too-big-to-fail” (TBTF) moral hazard incentives that could drive large banks to hold diversified but riskier asset portfolios.