The Impact of the 1988 Basel Accord on Banks' Capital Ratios and Credit Risk-taking: An International Study

Abstract

The purpose of this paper is to see whether and how G-10 banks have complied with the 1988 Basel Accord. The interest of this study lies in the fact that the standardized approach to credit risk in the New Basel Accord is conceptually similar to the 1988 agreement. However, very little is known about the reaction of non-US banks to the imposition of minimum capital requirements that make use of risk-weight categories. Building on previous studies, this paper uses a simultaneous equations model to analyze adjustments in capital and credit risk at banks from G-10 countries over the 1988-95 period. The results show that regulatory pressure was successful in raising the capital to assets ratios of undercapitalized banks in Canada, Japan, the UK and the US but not in France and Italy. In addition, there is no evidence that undercapitalized G-10 banks increased or decreased their credit risk over the period studied. Interestingly, these findings are robust to the inclusion of a variable measuring the role of market discipline in influencing bank capital and risk choices. All in all, the results suggest that the 1988 Basel standards were effective in that, subsequent to their adoption, undercapitalized G-10 banks generally increased their capital but not their credit risk.

The Effects of Bank Regulation on the Relationship Between Capital and Risk

“…With reference to the impact on capital, most of the studies find a positive impact of regulation, suggesting that banks subject to more regulatory pressure, tend to increase their capital ratio (Shrieves and Dahl, 1992;Jacques and Nigro, 1997), although some more recent investigations find a negative effect (Heid et al, 2003;Das and Ghosh, 2004;Ahmad et al, 2009). On the impact of regulatory pressure on risk exposure, findings suggest that a negative relationship exists (Shrieves and Dahl, 1992;Jacques and Nigro, 1997), but also in this case, contrasting evidence finds a positive or insignificant effect (Heid et al, 2003;Van Roy, 2005;Bouri and Ben Hmida, 2006).…”

“…Despite results in general show a strong negative relationship between capital and size (Jacques and Nigro, 1997;Aggarwal and Jacques, 2001;Rime, 2001;Heid et al, 2003;Kleff and Weber, 2008;Das and Ghosh, 2004;Lindquist, 2004;Murinde and Yaseen, 2004;Van Roy, 2005;Floquet and Biekpe, 2008;Matejašák et al, 2009), both the explanations cited above are supported within the empirical studies, as a number of studies find a weak negative or insignificant relationship between size and capital decisions (Shrieves and Dahl, 1992;Godlewski, 2005;Hussain and Hassan, 2005;Ahmad et al, 2009), and other studies find a positive relationship (Kleff and Weber, 2008, but limited to savings banks; Bouri and Ben Hmida, 2006, that concentrate on the Tunisian banking system).…”

“…Additionally, the impact of regulatory pressure varies depending on the ex-ante level of capital, as adequately and undercapitalized banks seem to be subject to different incentives (Rime, 2001;Godlewski, 2005;Murinde and Yaseen, 2004;Hussain and Hassan, 2005;Van Roy, 2005) and modify their behavior depending on the definition of capital (Kleff and Weber, 2008;Camara et al, 2013). The differences emerging in banks' behavior might be an effect of bank characteristics that can influence both capital and risk, and have therefore also been included in the analyses by the same empirical studies.…”

“…Larger banks are believed to be more diversified and this should contribute to a reduction of their risk exposure (Lindquist, 2004;Van Roy, 2005), although the evidence is mixed.…”

“…Additionally, as suggested by the literature, profitable banks might prefer to increase their capital through retained earnings, rather than equity as new issues might be negatively perceived by investors (Kwan and Eisenbeis, 1997;Rime, 2001;Van Roy, 2005;Matejašák et al, 2009), unless the increase in capital is imposed by the authorities (Kashyap et al, 2010).…”