Capital Regulation Reforms and Bank Risk-Taking in China

Bank capital stands at the heart of banking regulation aimed at curbing bank risk-taking. This paper examines the impact of the Chinese version of Basel III capital regulation on bank risk-taking in China, by applying panel regressions to a large sample of Chinese commercial banks. Our findings indicate that more Tier 2 contingent convertible (CoCo) bonds as capital instruments in the capital composition may paradoxically increase, rather than decrease, bank risk-taking. This effect is robust to instrumental variable estimation. A channel analysis reveals that this unintended effect primarily arises from a leverage effect. This is due to the strong debt attributes of Chinese Tier 2 CoCo bonds, leading to lower core capital levels. Conversely, no evidence is found for the franchise value effect as a significant driver. Lastly, we confirm that capital constraints influence banks' capital adjustments and asset risk allocation aligning with regulatory aims. Our paper has significant policy implications for financial regulation, shedding light on the efficacy of Basel III capital regulation while highlighting the limitations of Tier 2 CoCo bonds as capital instruments in China.