Does regulation only bite the less profitable? Evidence from the too-big-to-fail reforms

Summary

Focus

Did the enhanced regulatory framework put in place following the Great Financial Crisis lead to a systemic footprint reduction among large global banks? Has the response to the new rules differed across banks? We explore these questions through the lens of banks' diverse incentives to lower their footprint. While these incentives may be particularly attractive for banks facing high costs of raising capital, they may not be strong enough for banks that stand to lose a great deal from downsizing.

Contribution

Our analysis unveils the effect of the new regulatory framework on large global banks by benchmarking their response against the one of unaffected peer institutions. We show that profitability is a key – but often overlooked – determinant of banks' responses to regulatory reforms. Moreover, we establish a novel application of textual analysis to banks' annual reports in order to identify when the regulatory reform started affecting bank behaviour. This approach overcomes identification challenges that arise from the gradual implementation of new regulation.

Findings

We highlight the differential impact of the regulatory framework on large global banks. Only the less profitable ones reduced their systemic importance relative to equally unprofitable peers that were unaffected by the framework. The reduction was even stronger for those banks that were close to the regulatory thresholds that determine their capital surcharges. By contrast, the more profitable large global banks continued to raise their systemic footprint. The impact of the framework remains unnoticed if we study only its average effect on banks.

Abstract

Regulatory reforms following the financial crisis of 2007–08 created incentives for large global banks to lower their systemic importance. We establish that differences in profitability shape banks' response to these reforms. Indeed, profitability is key because it underpins banks' ability to generate capital and drives the opportunity cost of shrinking. Our analysis shows that only the less profitable banks lowered their systemic footprint relative to their equally unprofitable peers that were unaffected by the regulatory treatment. The more profitable banks, by contrast, continued to raise their systemic importance in sync with their untreated peers.

JEL Codes: G21, G28, L51

Keywords: global systemically important bank (G-SIB), textual analysis, capital regulation, systemic risk, bank profitability, difference-in-differences (DD)