The Effectiveness of Capital Regulation on Bank Behavior in China

• DOI: http://doi.org/10.1111/irfi.12045
• Published date: 01 September 2015
• Author: Ralf Zurbruegg,Lei Xu,Shih‐Cheng Lee,Yishu Fu
• Date: 01 September 2015

The Effectiveness of Capital

Regulation on Bank Behavior

in China*

YISHU FU†,SHIH-CHENG LEE‡,LEI XU§AND RALF ZURBRUEGG¶

†Institute of Chinese Financial Studies, Southwestern University of Finance and

Economics, Chengdu, China

‡Faculty of Finance, College of Management & Innovation Center for Big Data and

Digital Convergence, Yuan Ze University, Taoyuan, Taiwan

§Centre for Applied Financial Studies, School of Commerce, University of South

Australia, Adelaide, SA and

¶School of Accounting and Finance, University of Adelaide, Adelaide, SA, Australia

ABSTRACT

This paper examines the impact that ownership and governance structures

have on how Chinese banks react to regulatory pressure. We find that the

current regulatory regime induces banks to increase their capital, but its

effectiveness in doing so varies based on whether the bank is listed or not,

and also who is the majority shareholder. We also find that the degree of

central government ownership and the political ties the chief executive

officer of the bank has play an important role in the risk-taking behavior of

banks. Overall, our results have a number of policy implications supporting

the need to further reduce state ownership of banks in China to mitigate the

prevailing moral hazard and dual-agency problems that arise from the gov-

ernment being both the regulator and the majority shareholder.

JEL Codes: G21 G28

I. INTRODUCTION

The China Banking Regulatory Commission (CBRC) imposed major capital

adequacy requirements in 2004, partially in response to joining the World Trade

Organization (WTO) in 2001, with the need to re-capitalize the banking sector

and control expanding credit risk within the industry. Prior research by Hua

(2006) shows that up until then, regulatory pressure imposed little restraint on

capital levels and the risk-taking behavior of the banks. Although capital levels

in China have now significantly risen since the introduction of specific capital

adequacy requirements, its effectiveness may not be the same for all types of

* The authors wish to thank Shan Li and Takeshi Yamada for the assistance in earlier drafts of

the paper, plus the editor (Sudipto Dasgupta), an associate editor and an anonymous referee for

constructive comments in leading to the final version. All remaining errors are that of the

authors.

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International Review of Finance, 15:3, 2015: pp. 321–345

DOI: 10.1111/irfi.12045

© 2015 International Review of Finance Ltd. 2015

banks. Motivated by the literature that shows ownership and governance

factors can have an impact on risk-taking behavior, this paper examines how

effective this new regime has been in changing capital buffers and credit risk

behavior across different ownership and governance structures prevalent in

China.

From a theoretical perspective, it is uncertain how effective the current

regulatory regime is in China given the dual-agency nature of the Chinese

central government serving as the owner as well as the regulator for many of the

banks. Research has shown that ownership structure, and in particular the role

of the government, can have a major impact on firm’s behavior (see Shleifer and

Vishny 1986). In the context of Chinese banks, Garcia-Herrero et al. (2009)

found that the amount of government involvement can directly affect profit-

ability due to the fact that the government is using banks to assist in meeting

public policy goals as opposed to market-driven aims. On top of this, there is the

compounding effect from how governance structures may impact a bank’s

decision-making ability. Berger et al. (2014) comment how less is known about

corporate governance, and in particular board of director characteristics, in

affecting bank’s behavior. They also demonstrate that it can have a major

impact on bank’s risk-taking behavior. Furthermore, since the global financial

crisis, the role of good quality governance structures have been highlighted as

imperative to ensure risk-taking behavior is moderated. To this end, in 2010, the

Basel Committee on Banking Supervision (BCBS) released guidelines for

improving corporate governance in the banking industry (BCBS 2010). Within

the Chinese environment, there is the additional complication of the role

central government plays in determining governance structures. Heilmann

(2005), for example, showed that it is common for senior management to be

appointed by the government and are regarded as government officials.

In response to the above moral hazard issue, the Chinese central government

has, over the past decade, embarked on a substantial privatization program of its

banking sector. Therefore, in this context, this paper can also contribute to the

literature by examining whether bank’s behavior changes dependent on

whether it is listed or not, as listing requirements should theoretically provide

better public disclosure and practice. Sheshinski and Lopez-Calva (2003) also

argued that privatization should lead to more prudent operating decisions,

which will likely flow through to the risk-taking behavior of the banks. On the

contrary, the Chinese government has been known to provide generous support

[such as capital injections and nonperforming loan (NPL) bailouts] to state-

owned banks (Chen et al. 2005; Dobson and Kashyap 2006) and the question

remains even if the bank is securitized what impact this will have if the largest

shareholder is still the government. This study, therefore, can have some wide

and important implications for investors, bank managers, managed funds, and

policy makers in relation to how increased competition plus tightening regu-

lation affects the banking sector. Chinese banks are now important not only for

the growth and stabilization of the world but also in relation to the capitaliza-

tion of the major stock markets in East Asia. An understanding of how well

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