Bank regulation and stock market stability across countries
| Published date | 14 November 2016 |
| DOI | https://doi.org/10.1108/JFRC-09-2015-0049 |
| Date | 14 November 2016 |
| Pages | 402-419 |
| Author | Walaa Wahid ElKelish,Jon Tucker |
| Subject Matter | Accounting & Finance,Financial risk/company failure,Financial compliance/regulation |
Bank regulation and stock
market stability across countries
Walaa Wahid ElKelish
Department of Accounting, University of Sharjah,
Sharjah, United Arab Emirates, and
Jon Tucker
Centre of Global Finance, University of the West of England, Bristol, UK
Abstract
Purpose – The purpose of this paper is to investigate whether bank capital strength and external
auditing requirements inuenced international stock market stability during the 2007/2008 global
nancial crisis.
Design/methodology/approach – Bank mandatory regulation data are obtained from the World
Bank database, while stock market stability is gauged for 385 listed banks across 43 countries by means
of generalised least squares regression models.
Findings – The authors nd that mandatory capital strength requirements and the existence of
mandatory audit increase stock market stability across countries. Further, more protable banks
increase stock market stability. The results are robust to both country institutional settings and
economic freedom characteristics.
Originality/value – This paper provides evidence of the impact of bank regulations on stock market
stability during the global nancial crisis, thereby providing a useful insight for stakeholders to
enhance nancial regulation and policy.
Keywords Bank regulation, Financial crisis, Market stability, Capital strength, Mandatory audit
Paper type Research paper
1. Introduction
The stream of bank failures across the globe in the past two decades has encouraged
both national and international nancial institutions to introduce a raft of new bank
regulations to strengthen condence, stability and efciency in the sector. Many
governments and their banking sectors have invested signicant resources to ensure
compliance with these new regulatory measures to attract or maintain international
investment ows, to avoid future banking crises and to underpin broader stock market
stability. Empirical studies suggest that successive bank failures have been triggered
by both external institutional settings and internal, bank-specic factors. External
factors include inappropriate supervision, regulation, macroeconomic policies and
governance structures in relation to the nancial system (Delis and Staikouras, 2011;
Masciandaro et al., 2013). Other scholars present evidence of the impact of regulation
and supervisory policy on bank performance and efciency (Barth et al., 2004;Beck
et al., 2006;Chortareas et al., 2012). However, there is a dearth of research on the impact
of bank regulation on stock market stability. To address the shortcomings of the
JEL classication – G21, G28, M48, O16
The current issue and full text archive of this journal is available on Emerald Insight at:
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JFRC
24,4
402
Journalof Financial Regulation
andCompliance
Vol.24 No. 4, 2016
pp.402-419
©Emerald Group Publishing Limited
1358-1988
DOI 10.1108/JFRC-09-2015-0049
existing literature, the main purpose of this paper is to provide an international study of
the inuence of bank capital strength and external auditing requirements on stock
market stability during the global nancial crisis of 2007/2008, in so doing highlighting
issues and providing some pointers for the development of the international banking
industry. Our empirical results show that both mandatory capital strength
requirements and the existence of mandatory audit increase stock market stability
across countries. In addition, higher bank protability leads to greater stock market
stability.
Our paper contributes to the existing literature in several ways. First, it provides
evidence on the impact of capital strength and external auditing regulations on stock
market stability during the recent global nancial crisis, thereby providing some insight
for international nancial institutions, governments and regulators as countries seek to
enhance their nancial regulation and policy. Second, we show that banks need to
comply with tighter mandatory capital strength practices to legitimise their activities in
countries with weak institutions and economic freedom policies, thereby providing
support for an agency theory approach (Jensen and Meckling, 1976). Finally, our paper
provides some useful practical guidelines for policy-makers and regulators in both
developed and developing countries to support improved regulation for the purpose of
achieving greater stock market stability and to cope with the increasing complexity
which characterises the banking business environment.
The remainder of the paper is structured as follows. Section 2 presents the theoretical
and empirical literature and sets out the hypotheses to be tested. Section 3 discusses the
scope of the data, their collection and formatting and the statistical and modelling
methodology employed. The discussion of the empirical results is given in Section 4.
Finally, Section 5 summarises and concludes, and provides recommendations for both
policy-makers and future research in the eld.
2. Background and hypothesis development
2.1 Capital strength
The capital strength of a bank serves a risk-sharing function whereby capital is a buffer
against the improper disposal of assets as well as debt-holder losses (Kilinc and
Neyaphti, 2012). The rationale underpinning the regulation of capital strength is that
banks need to hold an appropriate level of capital to reduce the risk of failure and achieve
target operational efciency levels (Chortareas et al., 2012). Building on the agency
theory of Jensen and Meckling (1976),Dewatripont and Tirole (1994) argue that capital
requirements are employed as an instrument for the delegation of control rights to a
regulator on behalf of small depositors who are unwilling, or do not have the resources,
to monitor bank activities and assets during a nancial crisis. Recently, several scholars
highlight the relationship between bank capital requirements, bank behaviour (Borio
and Zhu, 2012), bank performance (Beltratti and Stulz, 2012;Berger and Bouwman,
2013;Chortareas et al., 2012), bank failure (Cole and White, 2012), output and ination
volatility (Angeloni and Faia, 2013) and the speed of bank capital structure adjustments
(Jonghe and Oztekin, 2015). For example, Borio and Zhu (2012) argue that ignoring a
minimum capital requirement can affect bank behaviour through reputational costs,
unfavourable market responses and new prudential procedures for bank risk
management frameworks. In this context, Berger and Bouwman (2013) study US banks
over the period 1984-2010 and nd empirical evidence that greater capital improves the
403
Bank
regulation
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