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Basel III capital regulations and bank profitability

Article  in  Review of Financial Economics · December 2017

DOI: 10.1002/rfe.1023

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Vighneswara Swamy
ICFAI Business School
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Received: 21 December 2017
| Revised: 26 January 2018
| Accepted: 20 February 2018

DOI: 10.1002/rfe.1023

ORIGINAL ARTICLE

Basel III capital regulations and bank profitability

Vighneswara Swamy

Economics and Finance, IBS-Hyderabad,

IFHE University, Hyderabad, India Abstract
This study models the impact of new capital regulations proposed under Basel III
Correspondence
framework on bank profitability in India by constructing a stylized representative
Vighneswara Swamy, Economics and
Finance, IBS-Hyderabad, IFHE University, bank’s financial statement. It shows that, with an increase in the capital ratio in
Hyderabad, India. the context of new capital regulations, the banks tend to experience a rise in inter-
Email: vswamypm@gmail.com
est income. The results indicate that in the case of scheduled commercial banks,
Funding information assuming that RWAs are unchanged, for 1-percentage point increase in capital
Indian Institute of Banking and Finance ratio, interest income would rise by 17 percentage points and would go up to an
(IIBF)
extent of 62 percentage points for six-percentage-point increase assuming that the
risk-weighted assets are unchanged. It also provides the estimations for different
groups of banks and the scenarios of changes in the risk-weighted assets, and
changes in the capital ratios.

JEL CLASSIFICATION
G2, G21, G28, E44, E51, E61

KEYWORDS
banks, basel III, capital, interest income, regulation

1 | INTRODUCTION
A growing strand of bank capital regulation literature in favor of the Basel III framework for bank capital regulations,
argues that there are significant macroeconomic benefits of raising bank equity. However, there have been debates about
the desirability and the impact of new capital regulations on the profitability of banks. Higher capital requirements lower
leverage and the risk of bank bankruptcies (Admati, DeMarzo, Hellwig, & Pfleiderer, 2010). On the other hand, there is
another strand of literature, which argues that there could be significant costs of implementing a regime with higher capital
requirements (Angelini et al., 2011, and Bank of International Settlements, 2010). The impact of Basel III regulations on
the banks is extensive and affects the bank’s day-to-day decision-making in lending, funding, treasury, capital, liquidity,
and operations. All these areas are closely interconnected, and directly affect the bank’s profitability.
Though literature is rich with studies on bank regulation and its impact (Cohen & Scatigna, 2016; Dermine, 2015; Diet-
rich, Hess, & Wanzenried, 2014; Lee & Hsieh, 2013; Pessarossi & Weill, 2015), very few studies are reported on the mod-
eling of the impact of capital and liquidity requirements on bank profitability except the one by Michael (2010). There is a
need to conduct country-specific studies for estimate the impact of new capital regulations under Basel III proposals on the
profitability of banks. This would provide the much-needed logic and rational approach toward ascertaining these impacts
to policymakers as well as build a body of literature capturing the uniqueness of country specific features (particularly of
emerging market economies such as that of India) in this direction.

The author expresses his gratefulness to Michael R. King, Bank for International Settlements, Basel, Switzerland, Prof. Tarun Mukherjee, University of
New Orleans and Prof. Shantaram Hegde, University of Connecticut for their valuable views and comments.

Rev Financ Econ. 2018;36:307–320. wileyonlinelibrary.com/journal/rfe © 2018 The University of New Orleans | 307

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