Summary:
Regulatory arbitrage and opacity of bank assets were important causes of the 2007-2008 global financial crisis. The full disclosure of information reduces the probability of bank bankruptcy and systemic risk. Banks with greater asset transparency are better able to convey solvency information to the outside world, which makes it easier to attract external refinancing. Conversely, the solvency uncertainty caused by asset opacity may lead to banking crises. Macro-prudential regulation, such as bank capital adequacy ratio regulation, has focused on regulating business on balance sheets. In this context, banks are motivated to move business outside their balance sheets to avoid financial regulation and profit from regulatory arbitrage. There are currently few theoretical or empirical studies on the effects of asset transparency and regulatory arbitrage on banks' systemic risk. This paper addresses the differences between interbank wholesale financing and retail deposits in depositor market supervision. It further addresses the use of wholesale financing (represented by interbank certificates of deposit) for regulatory arbitrage. Unlike traditional assets and liabilities such as deposits and loans, wholesale financing avoids both investor and depositor supervision and regulatory restrictions. This reduces bank asset transparency and makes banks take greater risks,and excessive connectedness. This paper first introduces the classical bank moral hazard model in relation to the concepts of bank asset transparency and regulatory arbitrage (represented by correlated risk). We further analyze the effects of asset transparency and regulatory arbitrage on banks' systemic risk from the perspective of theoretical modeling. We also undertake empirical analysis of these effects based on our theoretical model. Drawing on the Wind and Bankfocus databases, we use the rolling window, SRISK and MES methods to measure the asset transparency and systemic risk of China's commercial banks. We fully control for bank level characteristics and macroeconomic factors that may affect systemic risk. We find that regulatory arbitrage and low asset transparency lead to higher systemic risk. In the case of regulatory arbitrage, the correlation of bank risks and the risk externality of “rarely standing or falling alone” reduce the incentive for bank supervision. This results in collective failure and higher systemic risk. Banks no longer rely entirely on the deposit market for refinancing when interbank regulatory arbitrage occurs. The constraint of transparency on bank risk is weakened and the problem of moral hazard is further aggravated. As a lack of asset transparency weakens banks' financing ability in the deposit market, banks become more active in interbank regulatory arbitrage. Banks may opt for more opaque and risky investments. The homogeneity of assets and risk contagion from interbank certificates of deposit make the banking system more vulnerable. Regulatory arbitrage also weakens the effect of capital regulation on banks' systemic risk. This paper's contributions are as follows. First, we study systemic risk at the bank level. This paper relaxes the independence setting and introduces asset transparency in the case of heterogeneous portfolios (allowing correlation). We also study the influence of asset transparency on banks' systemic risk. This paper therefore enriches research on the relationship between DELR and bank accounting choice and individual/systemic risk. It also details the mechanism of regulatory arbitrage and its coordination with capital regulation. Second, we study the asymmetric responses of systemically important banks to deposit market supervision using correlation and the setting of creditor and debtor banks. This is another way to support research on the distortion of retail deposit markets by “too big to fail” banks. Third, we add to the retail deposit market literature from the perspective of the wholesale funding market and banks' systemic risk. We also fill the gap in research related tobank asset transpavency and wholesale funding such as shadow banking and Internet finance.
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