Behaviour of Capital and Risk Under Basel Regulations: A Simultaneous Equations Model Study of Indian Commercial Banks

Abstract

Implementation of Basel III guidelines necessitates, besides other measures, maintenance of additional capital buffers. The recommended capital adequacy ratio has been enhanced in phases to steer the banks gradually towards the ideal capital requirement. This study empirically examines the impact of regulations on the changes in capital and risk. An unbalanced panel data of Indian commercial banks, comprising 27 public and 31 private sector banks, is examined from 2002 to 2021. The capital adequacy ratio (CAR) maintained by the bank, against the minimum regulatory requirement, is used for the assessment of the target capital. The study employs a simultaneous equation model along with the Three Stage Least Square (3SLS) regression method. Two separate models based on risk weightage are employed to understand the relationship between capital and risk through the risk weight assignment. The findings suggest that the regulations have more impact on undercapitalized banks and the private sector banks have fared better than the public sector banks in sustaining higher CAR.

Keywords

Regulations capital adequacy ratio financial risk simultaneous equation

Get full access to this article

View all access options for this article.

References

Aggarwal

, & Jacques

K. T.

(2001). The impact of FDICIA and prompt corrective action on bank capital and risk: Estimates using a simultaneous equations model. Journal of Banking & Finance , 25(6), 1139–1160.

Antoun

, Coskun

, & Youssef

(2021). Bank-specific, macroeconomic, and institutional factors explaining the capital buffer and risk adjustments in banks: A simultaneous approach. Eastern European Economics , 59(2), 103–124. https://doi.org/10.1080/00128775.2020.1870406

Basher

S. A.

, Kessler

L. M.

, & Munkin

M. K.

(2017). Bank capital and portfolio risk among Islamic banks. Review of Financial Economics , 34, 1–9. https://doi.org/10.1016/j.rfe.2017.03.004

Behr

, Schmidt

R. H.

, & Xie

(2010). Market structure, capital regulation and bank risk taking. Journal of Financial Services Research , 37(2–3), 131–158. https://doi.org/10.1007/s10693-009-0054-y

Ben Salah Mahdi

, & Boujelbene Abbes

(2018). Relationship between capital, risk and liquidity: A comparative study between Islamic and conventional banks in MENA region. Research in International Business and Finance , 45, 588–596. https://doi.org/10.1016/j.ribaf.2017.07.113

Cannata

, & Quagliariello

(2006). Capital and risk in Italian banks: A simultaneous equation approach. Journal of Banking Regulation , 7(3–4), 283–297. https://doi.org/10.1057/palgrave.jbr.2350029

Cooper

D. R.

, & Schindler

P. S.

(2003). Business research methods . Mcgraw-hill.

Das

, & Ghosh

(2004). The relationship between risk and capital: Evidence from Indian Public Sector Banks (RBI Occasional Papers). RePEc

Deelchand

, & Padgett

(2009). The relationship between risk, capital and efficiency: Evidence from Japanese cooperative banks. SSRN Electronic Journal . https://doi.org/10.2139/ssrn.1525423

10.

Demirguc-Kunt

, Detragiache

, & Merrouche

(2013). Bank capital: Lessons from the financial crisis. Journal of Money, Credit and Banking , 45(6), 1147–1164. https://doi.org/10.1111/jmcb.12047

11.

Diamond

D. W.

, & Dybvig

P. H.

(1983). Bank Runs, Deposit Insurance, and Liquidity. Journal of Political Economy , 19.

12.

Ediz

, Michael

, & Perraudin

(1998). The impact of capital requirements on U.K. Bank behaviour. SSRN Electronic Journal . https://doi.org/10.2139/ssrn.1024836

13.

Flannery

M. J.

(1989). Capital regulation and insured banks choice of individual loan default risks. Journal of Monetary Economics , 24(2), 235–258. https://doi.org/10.1016/0304-3932(89)90005-6

14.

Furlong

F. T.

, & Keeley

M. C.

(1989). Capital regulation and bank risk-taking: A note. Journal of Banking and Finance , 13, 883–891.

15.

Ghosh

, Nachane

D. M.

, Narain

, & Sahoo

(2003). Capital requirements and bank behaviour: An empirical analysis of Indian public sector banks: Capital requirements and bank behaviour. Journal of International Development , 15(2), 145–156. https://doi.org/10.1002/jid.947

16.

Godlewski

C. J.

(2005). Bank capital and credit risk taking in emerging market economies. Journal of Banking Regulation , 6(2), 128–145. https://doi.org/10.1057/palgrave.jbr.2340187

17.

Jacques

, & Nigro

(1997). Risk-based capital, portfolio risk, and bank capital: A simultaneous equations approach. Journal of Economics and Business , 49(6), 533–547. https://doi.org/10.1016/S0148-6195(97)00038-6

18.

Jokipii

, & Milne

(2011). Bank capital buffer and risk adjustment decisions. Journal of Financial Stability , 7, 165–178.

19.

Kapoor

, & Kaur

(2018). The impact of Basel norms on the capital and risk behavior of Indian Banks . 4, 17.

20.

Kim

, & Santomero

A. M.

(1988). Risk in banking and capital regulation. The Journal of Finance , 43(5), 1219–1233. https://doi.org/10.1111/j.1540-6261.1988.tb03966.x

21.

Lindgren

C.-J.

, Garcia

G. G.

, Saal

M. I.

, & Garcia

(1998). Bank soundness and macroeconomic policy (Reprinted February). Internat. Monetary Fund.

22.

Maji

S. G.

, & De

U. K.

(2015). Regulatory capital and risk of Indian banks: A simultaneous equation approach. Journal of Financial Economic Policy , 7(2), 140–156. https://doi.org/10.1108/JFEP-06-2014-0038

23.

Maji

S. G.

, & Hazarika

(2018). Capital regulation, competition and risk-taking behavior of Indian banks in a simultaneous approach. Managerial Finance , 44(4), 459–477. Scopus. https://doi.org/10.1108/MF-09-2017-0340

24.

Mireku

, Sakyi

E. A.

, & Agana

J. A.

(2018). Does commercial banks presence enhance profitability in Ghana? Global Business Review , 19(6), 1449–1461. https://doi.org/10.1177/0972150918794969

25.

Modigliani

, & Miller

M. H.

(1958). The cost of capital, corporation finance and the theory of investment. The American Economic Review , 48(3), 261–297. http://www.jstor.org/stable/1809766

26.

Myers

S. C.

(1984). The capital structure puzzle. The Journal of Finance , 39(3), 574–592. https://doi.org/10.1111/j.1540-6261.1984.tb03646.x

27.

Nachane

D. M.

, Narain

, Ghosh

, & Sahoo

(2001). Bank response to capital requirements: Theory and Indian evidence. Economic and Political Weekly , 36(4), 329–335. http://www.jstor.org/stable/4410231

28.

Naik

P. K.

(2020). Determinants of banks’ debt: Dynamic panel evidence from Indian public sector banks. International Journal of Accounting and Finance , 10(1), 16.

29.

Peltzman

(1970). Capital investment in commercial banking and its relationship to portfolio regulation. Journal of Political Economy , 78(1), 1–26. https://doi.org/10.1086/259597

30.

Pham

H. L.

, & Daly

K. J.

(2020). The impact of BASEL accords on the management of Vietnamese commercial banks. Journal of Risk and Financial Management , 13(10), 228. https://doi.org/10.3390/jrfm13100228

31.

Rime

(2001). Capital requirements and bank behaviour: Empirical evidence for Switzerland. Journal of Banking & Finance , 25(4), 789–805. https://doi.org/10.1016/S0378-4266(00)00105-9

32.

Sahoo

Ashwani. (2020). COVID-19 and Indian economy: Impact on growth, manufacturing, trade and MSME sector. Global Business Review , 21(5), 1159–1183. https://doi.org/10.1177/0972150920945687

33.

Shrieves

R. E.

, & Dahl

(1992). The relationship between risk and capital in commercial banks. Journal of Banking & Finance , 16(2), 439–457. https://doi.org/10.1016/0378-4266(92)90024-T

34.

Stolz

, Heid

, & Porath

(2003). Does capital regulation matter for bank behavior? Evidence for German savings banks. SSRN Electronic Journal . https://doi.org/10.2139/ssrn.493723

35.

Swamy

D. V.

(2013). Basel III: Implications for Indian Banking (p. 162). IBS Finance.

36.

Swamy

(2018). Modeling the impact of Basel III regulations on loan demand. Journal of Financial Economic Policy , 10(1), 136–164. https://doi.org/10.1108/JFEP-06-2017-0057

37.

Tang

, Chen

, Wang

, Chen

, & Yang

(2009). Discriminant analysis of zero recovery for China’s NPL. Journal of Applied Mathematics and Decision Sciences , 2009, 1–16. https://doi.org/10.1155/2009/594793

38.

Wall

L. D.

, & Peterson

D. R.

(1987). The effect of capital adequacy guidelines on large bank holding companies. Journal of Banking & Finance , 11(4), 581–600. https://doi.org/10.1016/0378-4266(87)90004-5

39.

Werner

R. A.

(2016). A lost century in economics: Three theories of banking and the conclusive evidence. International Review of Financial Analysis , 46, 361–379. https://doi.org/10.1016/j.irfa.2015.08.014

40.

RBI, Narsimham Committee. (1991). Report of the committee on financial system . https://rbidocs.rbi.org.in/rdocs//PublicationReport/Pdfs/CR212_1991D7922889FE4042C4BFE3F52A9D293F23.PDF

41.

RBI. (2002). Master circular prudential norms on capital adequacy . DBOD No. BP. BC. 2/21.01.002/2002-2003.

42.

RBI. Master circular - prudential norms on income recognition, asset classification and provisioning pertaining to advances. DOR.No.STR.REC.55/21.04.048/2021-22. https://www.rbi.org.in/Scripts/BS_ViewMasterCirculardetails.aspx

43.

RBI. (2015). Master circular on Basel III capital regulations . RBI/2015-16/58 DBR.No.BP.BC.1/21.06.201/2015-16.

44.

BCBS. (2006). Basel Committee on Banking Supervision, Bank for International Settlements. https://www.bis.org/basel_framework/.