Banking deregulation's double-edged sword: Boosting credit but raising financial stability risks

Background and Motivation

The impact of banking deregulation on economic growth and firm activity is well-documented. However, a crucial question has remained largely unexplored: how does deregulation directly affect the risk-taking behavior of banks themselves? This research gap is significant, as understanding this link is vital for crafting policies that support economic development without precipitating financial crises. This study was motivated to investigate this exact dynamic, using a major deregulation event in China as a natural experiment to uncover the effects on bank risk-taking from a balance sheet capacity perspective.

Methodology and Scope

The research focused on China's 2009 banking deregulation as an exogenous policy shock. Employing a rigorous difference-in-differences (DID) approach, the study compared the behaviour of deregulated banks against a control group to isolate the causal effect of the policy. To delve into the underlying mechanisms, the researchers implemented a sophisticated three-stage regression strategy, allowing them to trace the pathway from deregulation to increased risk-taking.

Key Findings and Contributions

• Increased Bank Risk-Taking: The primary result confirms that banks affected by the deregulation exhibited significantly higher levels of risk-taking compared to their non-deregulated peers.
• Balance Sheet Capacity: The study identifies a clear causal channel. Deregulation helped strengthen the net interest margins of the affected banks. This improvement in profitability enhanced their balance sheet capacity, which in turn increased their risk appetite.
• A Clear Benefit for the Real Economy: On the positive side, the deregulation improved access to long-term credit for firms in regions with previously limited credit availability. This effect was especially pronounced for smaller firms, demonstrating a successful expansion of the financial sector's service outreach.
• The Core Dilemma: The research crystallises a fundamental policy trade-off: banking deregulation supports the real economy through enhanced credit availability but does so at the cost of increased risk within the banking system.

Why It Matters

This research moves the conversation beyond whether deregulation is simply "good" or "bad." It provides a nuanced framework for understanding its dual nature. For regulators and central banks, the findings underscore that policies aimed at stimulating credit growth and supporting small businesses cannot be evaluated in isolation; they must be consciously balanced against the accumulation of systemic risk in the financial sector.

Practical Applications

• For Financial Regulators: The study serves as a critical reminder to couple pro-competition deregulation with parallel enhancements in risk-based supervision and macroprudential tools. Monitoring metrics like net interest margins and balance sheet strength can serve as early warning indicators for rising risk appetites.
• For Bank Management: Boards and risk committees at banks benefiting from deregulatory measures should be aware of the inherent pressure to increase risk-taking. They must proactively strengthen their internal risk governance to ensure that enhanced capacity is deployed prudently.
• For Policymakers: When designing financial liberalisation policies, governments must explicitly acknowledge and plan for this trade-off. The goal should be to capture the benefits for the real economy while implementing safeguards to mitigate the associated risks to financial stability.

Discover high-quality academic insights in finance from this article published in China Finance Review International. Click the DOI below to read the full-text original!