A new study shows the carrot is more effective than the stick in incentivizing bank compliance with capital requirements.
Banks must keep a certain amount of money aside to shield themselves and their customers from potential losses. This "reserved" money, known as regulatory capital, played an important role in the 2007-2008 financial crisis when it became clear that risky lending practices and weak regulatory oversight could bring banks down and hurt the whole economy.
Generally, banking rules are a punishment-based system (i.e., pay a fine if you don't follow the rule). In a recent study, my co-author and I investigated how banks behave when rules are set in a reward-based system (i.e., good things happen when you do more than required).
In the U.S., a rule says banks should keep a minimum of 8% of their funds as reserve money. However, if they go beyond this and reach the 10%, they get perks like lower insurance fees, increased access to certain types of capital, and access to financial activities beyond traditional banking.
Banks want to follow the rules
Our main finding is that banks are more likely to report capital levels just above 10% than just below it. This highlights how banks are strongly influenced to comply with higher capital standards.
Banks use various methods to meet the 10% capital reserve requirement, including increasing equity and employing accounting discretion. Accounting discretion refers to the flexibility banks have in how they report their financial numbers, often within the rules but influenced by their goals. The methods banks use vary depending on the size of the capital shortfall, and equity financing is more prevalent for larger gaps.
However, when such strong incentives exist, the risk is that compliance occurs by artificially managing the accounting numbers. While equity financing supports financial stability, accounting discretion poses risks, undermining financial transparency and potentially compromising long-term stability.
Strong incentives also carry risk
The study shows that rewarding banks for meeting clear goals can encourage them to hold more capital and make the system safer. Giving banks access to more financial activities was the main incentive for banks to be above the 10% threshold. However, regulators must watch for risks like accounting management and adjust rules based on actual bank behavior to maintain stability.
Findings from this research apply not only to U.S. banks but also to European and Norwegian banks that follow similar rules. Policymakers can use this research to build regulations that reward banks, promoting better banking practices and a more stable financial system.