Being Agile to Thrive Amidst Disruptive Digital Innovations

We examine the effects of the revised Basel II rules on bank managers’ discretionary behavior. Specifically, we ascertain whether bank managers engage in more income smoothing and whether they defer loan loss provisioning as a result of increased regulatory pressure from anticipated changes to the Basel Accord. We predict that the revised rules will increase regulatory pressure on the corporate banking business which is likely to be more affected than the retail banking business by these changes. Corporate banking managers may react by reducing risk-taking activities or by increasing income smoothing activities. We find evidence of greater (less) income smoothing in the corporate banking business of low-capital (high-capital) banks during the Basel II period. We also find that corporate banking managers of these weaker banks recognize loan loss provisions in a less timely manner. In contrast, we do not find these effects for retail banking businesses. Finally, we find that the market reacts negatively to Basel II regulatory announcements initially but the adverse market reaction reduces over time. Overall, our study provides evidence of unintended consequences arising from the changes to banking rules as proposed under Basel II.