Does Stringent Capital Regulation with Voluntary Adoption Incentivize Risk-Taking?

This study investigates whether tougher capital requirements with voluntary adoption encourage aggressive small banks’ risk-taking behavior. The community bank leverage ratio framework in the US (effective from the first quarter of 2020) is utilized as a case study of stringent but voluntary capital regulation. After analyzing quarterly data on 3260 community banks, we find that stringent capital has a significant causal relationship with aggressive banks’ increased risk-taking. Voluntary stringent capital regulation offers risk-taking incentives that motivate aggressive banks’ adoption and result in more risk-taking. The findings are robust to alternative samples, risk definitions, estimation methods, and model specifications.