BIS capital standards and supply of bank loans: Evidence from an emerging market

Abstract

The regulatory capital standards for banks have moved towards risk based approaches ever since the Bank for International Settlements (BIS) sponsored Basle Capital Accord of 1988 has been implemented. The Basle Accord linked the capital requirement of banks to the risk of the assets of the bank with risk weights assigned to different asset categories. The Basle Accord was partly in response to a series of international bank failures and concern over unequal national capital standards. The Basle Accord was questioned on several fronts. One issue that received attention of researchers was whether the Basle Accord was responsible for the global economic slowdown in the early 1990s. The empirical evidence on the impact of BIS capital standards on bank asset allocation is mixed. While some studies find evidence of banks reducing their loan allocation (Shrieves and Dahl (1992), Nigro and Jacques (1997) and Aggarwal and Jacques (1997), Rime (1998), Peek and Rosenberg (1997)) others such as Burger and Udell (1994), find results inconsistent with the proposition that capital pressure was the origin of the US credit crunch in the early 1990s. In this paper, a two period model of a bank is used to analyze the impact of bank asset allocation decision under minimum capital adequacy requirement. In period zero, the bank has no minimum capital requirements and banks allocate resources in period zero to meet cash reserve requirement (CRR) and a treasury investment requirement, which in India is referred to as the statutory liquidity requirement (SLR) both of which are imposed by the regulator. Since yield on loans is higher than the yield on treasury investments, a revenue maximizing bank would allocate the maximum assets to loans after meeting the minimum regulatory CRR and SLR norms. In period one, the bank is faced with an additional regulatory burden in the form of a minimum capital adequacy ratio. The bank has to choose to allocate its assets so as to maximize revenue subject to the CRR, SLR and minimum capital adequacy constraint. It is found that while the initial capital level has a positive effect on loan allocation, minimum capital adequacy requirement is negatively related to loan allocation. The other results are that the efficiency of the bank, which is captured by the return on assets ratio, has a positive impact on loan allocation while the risk weight on loans have a negative effect on the supply of loans. The results of the optimization exercise show that when the bank is severely capital constrained such as when the initial capital ratio is 6%, and the minimum capital adequacy ratio is 9%, the bank would reduce the supply of loans. This shows that capital constrained banks would reduce the supply of loans. Regulators while designing and implementing risk based capital standards would need to balance the concerns regarding bank safety with the availability of bank credit in the economy.