Risk Taking Behavior and Capital Adequacy in a Mixed Banking System: New Evidence from Malaysia using Dynamic OLS and Two-step Dynamic System GMM Estimators

The financial and banking crises around the world have prompted the regulators to revise, among others, the capital level of the banks to deal with the excessive risks taken by the banks, both conventional and Islamic. This study is the first attempt to investigate the relationship between risky assets and capital level in a mixed banking system applying the panel VECM and dynamic GMM estimators. The Malaysian mixed banking system is used as a case study taking panel data covering the period from December 2006 to October 2013. Our statistical results based on dynamic OLS (DOLS) tend to indicate that there is a positive relationship between the capital ratio (CAR) and risk weighted asset ratio (RWA) in the long run and also, the causality analysis based on panel VECM and two-step dynamic System GMM tends to indicate unidirectional causality in that the RWA is positively driven by CAR. Our results appear to suggest that higher capital buffer (excess capital above regulatory capital requirement) might have opened up more space for bank managers to taking risky positions while assisted by increasing domestic demand for credit facilities under favorable economic condition of Malaysia. In other words, high capital growth and capital buffer provides an extra cushion for Malaysian banks to pursue relatively riskier financing activities. For the full-fledge Islamic banks (IB) and Islamic bank subsidiaries (IBS), the existence of a cointegrating relationship between RWA and CAR suggests that the way the managers of Islamic banks behave towards risky assets follows the conventional practice.