Chapter 4 Does Financial Regulation Affect the Profit Efficiency and Risk of Banks? Evidence
3. Literature Review
5.2 The Relationship between the Financial Regulation and Efficiency and Risk
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5. Empirical Analysis 5.1 The Correlation Analysis
We further study whether the characteristic of financial regulation affects the efficiency and risk of bank. We then used the Tobit (OLS) regression model to determine the relationship between the financial regulation and the profit efficiency (i.e., risks) of large and small banks.
We apply the correlation analysis on explanatory and explained variables to examine multicollinearity. The correlation coefficient of the capital adequacy ratio was highly related with leverage ratio (0.805). Appendix Table A4-4 lists the coefficient of correlation.
5.2 The Relationship between the Financial Regulation and Efficiency and Risk
The explained variables in the Tobit regression model were obtained from the profit efficiency in the profit model; the explained variables in the OLS regression model were obtained from the Z-score. Then, we estimate the relationship between financial regulation and the profit efficiency and risk of bank between 2004 and 2011. As shown in Table 4-5.
Table 4-6 lists the significant empirical results. Table 4-7 summarizes of hypotheses results.
Asset Quality
The loan loss provision ratio had a significant positive effect on efficiency of large banks.
The higher the ratio is, the higher the efficiency of a bank. The coefficient for the provision coverage ratio is significantly positive, which implies that the higher the ratio is, the lower the risk for a bank. This shows that large banks have greatly enhanced the ability to resist risks.
But, these two ratios did not a significantly affect small bank’s efficiency and risk.
Benefit and Efficiency
The cost to income ratio had a significant negative effect on efficiency of large and small banks. The higher the cost-to-income ratio is, the lower the efficiency of a bank. For large banks, the coefficient of cost to income ratio is significantly negative. The higher the cost to income ratio, the more risk for a bank. But, the ratio did not a significantly affect small bank’s risk. This shows that large banks should pay more attention to the cost of control than small banks should.
Liquidity
The current ratio had a significantly negative effect on the efficiency of large banks; a higher ratio of liquidity may significantly impede the efficient operation of banks because of fund idle. But, the current ratio had a significant positive effect on efficiency of small banks.
The purpose of CBRC regulates the current ratio is reduce the risk of bank. By our empirical results, the current ratio did not affect the risk and lead to different efficiency results of large and small banks
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Loan to deposit ratio only affect the efficiency and risk of small banks. The higher the ratio, the less efficiency and more risk for a bank. Therefore, the CBRC regulates the ratio seems reasonable and meaningful for small banks. The loan to deposit ratio did not a significantly affect large bank’s efficiency and risk. The loan to deposit ratio of large banks is lower than small banks, the sources of funding is more stable.
Capital Adequacy
The capital adequacy ratio and leverage ratio did not a significantly affect large bank’s efficiency and risk. For small bank, the capital adequacy did not a significantly affect on efficiency, but it can reduce the risk. The leverage ratio had a significant positive effect on efficiency of small bank. The higher the ratio is, the lower the risk for a bank. The capital requirement can reduce the risk of small banks.
Control Variable
The establishment time had a significant negative effect on efficiency of large banks. The longer the establishment time, the lower efficiency and risk for a bank.
Table 4-5 distinguishes between large and small banks and lists the significant empirical results. An increase in the provision coverage ratio, however, can reduce the risks of large banks. The coefficient for the cost-to-income ratio is significantly negative, which implies that a higher ratio indicates a lower efficiency and greater risk for large banks. Therefore, the CBRC regulates the provision coverage ratio and cost-to-income ratio, which seems relevant to large banks. However, these two ratios had no effect on the risks of small banks. For small banks, the loan-to-deposit ratio is significantly negative, implying that the ratio increases as risks increase. A higher loan-to-deposit ratio implies lower efficiency. Small banks with higher capital adequacy ratios and leverage had lower risks. Nevertheless, these three ratios did not significantly affect the risks of large banks.
We think the adoption of the New Standards is likely to put pressure on Chinese banks. It is imperative for commercial banks to change the profit model. Especially, as China commercial banks still follow the conventional business model which highly dependent on credit supply to make profit. The scale expansion of loan will bring an increase in capital. In order to keep up with the regulatory requirements on capital adequacy ratio, bank will be faced with the needs for capital supplementation. Then, the new capital requirements will greatly restrict commercial banks’ credit expansion. Upon the implementation of the new rules, Chinese banks will have to consider possible ways of replenishing capital again.
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Table 4-5 The relationship between financial regulation and profit efficiency and risk for large and small banks
Explained variable Efficiency Risk
Model Model 1 Model 2 Model 3 Model 4
Bank type Large banks Small banks Large banks Small banks Large banks Small banks Large banks Small banks Coeff.(SD)
R-squared 0.4490 0.0546 0.3373 0.0560
Adjusted R-squared 0.3878 0.0243 0.2637 0.0257
Note：***, **, * represent significance at the 1%, 5%, and 10% levels, respectively.
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Table 4-6 Significant results under the Tobit and OLS regression model：distinguish between large and small banks
Large bank Small bank
Regulation variable
Efficiency Risk Efficiency Risk
RES_NPL no effect positive no effect no effect
RES_Loan positive no effect no effect no effect
CIR negative negative negative no effect
LIQ negative no effect positive no effect
LDR no effect no effect negative negative
CAR no effect no effect no effect positive
Leverage no effect no effect positive positive
Time negative positive no effect no effect
Note: (positive) indicates that the regulation variable had a significantly positive effect on the efficiency (risk) of large (small) banks；(negative) indicates the regulation variable had a significantly negative effect on the efficiency (risk) of large (small) banks.
6. Conclusion
The CBRC released a set of guidelines for the banking industry, including imposing requirements on capital bases, leverage, provision and liquidity. This research investigated the characteristics of China's financial regulations and explored how the regulations affect the profit efficiency and risk of commercial banks in China. The CBRC regulates the current ratio to reduce the risks of banks. Based on our empirical results, the current ratio did not affect the risks and led to different efficiency results between large and small banks.
The empirical results indicate that an increase in the provision coverage ratio can reduce the risks of large banks. A higher cost-to-income ratio implies lower efficiency and greater risks for large banks. Conversely, these two ratios had no effect on the risks of small banks.
Therefore, the CBRC regulates the provision coverage ratio and cost-to-income ratio, which seems relevant to large banks. Small banks with a higher capital adequacy ratio and leverage have higher efficiency and lower risks. For small banks, the loan-to-deposit ratio increases as risks increase. A higher loan-to-deposit ratio implies lower efficiency. However, these three ratios did not significantly affect the risks of large banks. Similarly, the CBRC regulates the loan-to-deposit ratio, capital adequacy ratio, and leverage ratio, which seems relevant to small banks.
In an environment with asymmetric information, a bank decision-making is unobservable. The characteristics of financial regulation provide market clues if a bank is
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operating at the most efficiency condition. This also explains that the policymaker and banks face a trade-off between financial risk and efficiency. Stricter regulation may be good for bank stability (reduce risk), but not for bank efficiency. In order to fit the new requirements, it is imperative for commercial banks to change the profit model. Therefore, the banking sector should make more efforts on credit structure adjustment and credit quality improvement in the coming period of time, which is also the expected goal of the CBRC in its efforts to boost the implementation of new regulatory standards.
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Table 4-7 Summaries of hypotheses results
Efficiency Risk
Efficiency and risk
Regulation index and hypothesis Large bank Small bank Large bank Small bank
Regulation index
Hypothesis Descriptions Model 1 Model 2 Model 1 Model 2 Model 3 Model 4 Model 3 Model 4
H1 The provision coverage ratio has no effect on the profit efficiency (or risk) of a bank.
consistent consistent consistent consistent inconsistent consistent consistent consistent Asset
Quality
H2 The loan-loss provision ratio has no effect on the profit efficiency (or risk) of a bank.
consistent inconsistent consistent consistent consistent consistent consistent consistent
Benefit and Efficiency
H3 The cost to income ratio has no effect on the profit efficiency (or risk) of a bank.
inconsistent inconsistent inconsistent inconsistent inconsistent inconsistent consistent consistent
H4 The current ratio has no effect on the profit efficiency (or risk) of a bank.
inconsistent consistent inconsistent consistent consistent consistent consistent consistent Liquidity
H5 The loan to deposit has no effect on the profit efficiency (or risk) of a bank.
consistent consistent consistent inconsistent consistent consistent consistent inconsistent
H6 The capital adequacy ratio has no effect on the profit efficiency (or risk) of a bank.
consistent consistent consistent consistent consistent consistent inconsistent consistent Capital
Adequacy
H7 The Leverage ratio has no effect on the profit efficiency (or risk) of a bank.
consistent consistent consistent inconsistent consistent consistent
％
consistent inconsistent
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Chapter 5 Concluding Remarks and Future Researches