Do Well-Capitalized Banks Take More Risk? Evidence from the Korean Banking System

The relationship between banks' capitalizations and risk-taking behaviors has been one of the central issues in the banking literature because of its implications on regulatory policies. Despite the fact that a considerable amount of studies have been conducted concerning the issue, neither empirical nor theoretical studies reach a consensus. The aim of this paper is to provide an empirical study on this issue on the basis of new hypotheses and methodologies not utilized in previous studies. We build a testing model that incorporates the different incentives of the three entities that affect the risk determination of a bank; namely regulatory agencies, shareholders, and management. The test results using data from the Korean banking system show apparent differences in risk-capitalization relationships across banks differentiated by the level of capitalization, and across publicly and non-publicly-traded banks. These results provide clear evidence that the risk-capitalization relationships are, indeed, sensitive to the relative forces of the three sources of influence in determining asset risk.