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Pakistan Journal of Social Sciences

THE IMPACT OF BANK CAPITAL REGULATION IN The results of the two methods were not significantly different. The
simulations based on Vector Autoregressive (VAR) method indicate the
BY importance of growth of economic activities (growth of GDP) as a major

Abdullateef Usman, PhD determinant of change in deposits and change in loans. The view that banks
Department of Economics University of Ilorin
e-mail: - choose to shrink their balance sheet activities during the capital shocks is
Ibrahim Waheed consistent with the findings.
Department of Economics University of Ilorin KEYWORDS: Banks, Capital Requirement, Nigeria

The increasing integration of international financial markets poses

new challenges to domestic financials markets everywhere, especially in

ABSTRACT developing countries. The financial crises of the last decades (90’s) sounded
This paper provides new evidence on the effects of banking sector wake up calls to most developing countries, indicating that regulation and
recapitalization in Nigeria. It set up a simple model of the banking firm, to supervision needed to be strengthened substantially. Since then, important
investigating the impact of capital regulation on banks behavior as well as steps have been taken to set rules and ensure their implementation (Barbara
having possible effects on the economy. Time series data covering the year S. 2001).
1970-2004 were fitted to the regression model using both Ordinary Least At international realm, the Basle Capital Adequacy Accord (Basle 1)
Square (OLS) and Vector Error Correction (VEC) method of estimations. introduced in 1988, was a milestone in banking regulation. The accord

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which recommended 8 percent minimum capital requirement for stage and the effects of those implemented are being awaited by the

internationally active banks was adopted by over 100 countries (developed populace.

and developing). The accord clearly improved financial stability of all the The review of developments in the Nigerian banking and financial

member countries (Yudistira D. 2003). In spite of many convincing system indicates that the banking sector has undergone remarkable change

arguments for Basle accord, there are concerns and apprehension in over the years, in terms of the number of institutions, ownership structure,

developing countries of possible negative impact in the early phase of its as well as the scale of operations. This is largely driven by the deregulation

implementation. of the financial sector in order to conform to the international standards. As

From theoretical and empirical sights, capital requirements lead to a sudden at the end of June 2006, the number of insured banks stood at 25 with

contraction of bank lending i.e. the fixed minimum requirement of capital various sizes and degree of soundness (Adam J.A. 2005).

changes the behavior of banks to shrink their balance sheets and in effect, it In Nigeria, there have been several empirical attempts to assess the

creates a slow down in the growth of economy (Yudistira D. 2003). The performance of financial reforms2 (see ikhide and Alawode, 1994, ikhide,

concerns have also been expressed for developing countries where the 1998, Soyinbo and Adekanye, 1992, Sobodu and Akiode, 1994, among

possible negative impact of capital requirements seem to be more relevant, others). There are other studies that assess the performance of financial

giving a larger role of banking system in emerging countries. It is in the sector reforms in Nigeria in comparison to other countries in sub-Sahara

light of these concerns that this paper focused on Nigeria, especially in the Africa (Soyinbo, 1994, Aryeetey, 2000, Emenuga, 1998, Aryeetey and

period when her banking reforms programme is moving towards an advance Senbel, 1998 among others). Surprisingly, none of these studies has given a

comfortable pass mark for financial sector reforms in Nigeria.

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In an attempt to evaluate and predicts the possible impact of bank The survey of evidence on the effectiveness of capital requirements

recapitalization process on the behavior of the banks and the economy in indicates two significant aspects; the first concentration of the study is to

general, we draw experience from related literature. But the study differs investigate whether banks fulfill the capital requirements by increasing

from earlier studies in a slight manner. Instead of approaching the problem capital or by altering the risk-weighted assets5. The second portion of

in a holistic manner, we set up a simple behavioral model of the banking the literature, and most relevant to this paper is to test whether the

firm, and fitted time series data to obtain estimates of the parameter. The enforcement of capital requirements can lead to a contradiction in banks’

model is then simulated for both anticipated and the surprise elements of the supply of loans or best described as credit crunch6. This particular channel

policy actions4. Apart from the paucity of indicators used as evaluation describes how monetary shocks to balance sheet might affect the cost of

criteria, we believe, the results obtained can aid and guide further finance for certain borrowers over and above the standard impact in finance

implementation of the policy at a more macro pattern. costs of higher interest rates (Bernanke and Gertler 1995). A formal

The rest of this paper has been organized into five (5) sections. Section II analysis by Blum and Hellwig (1995) shows a relationship between bank

surveys theories relating to the impact of capital regulations, and a briefly equity and bank lending may amplify macroeconomic cycles, tempting

overview of the banking sector reforms in Nigeria. In section III is devoted banks to lend less when times are bad and to lend more when times are

for methodology while section IV presents and analyze the results obtained good. By presenting the strong relationship between bank’s asset side and

in section III. Section V gives the summary, conclusion and liabilities side, Diamond and Rajan (2000) confirms that capital

recommendations. requirements have obvious effects in the short run which is credit crunch

II. The impact of capital regulations: related literature where as delicate outcome in the long run which creates banks to be more

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risky in their performance (see also furfine 2000: Ito and Sasaki, 1998, from January, 1992. Effective from 1989, the minimum paid-up capital for

Agung et al 2001 among others). commercial banks was increased from 10 million naira to 20 million naira,

Bank Capital Regulation in Nigeria it moved to 50 million naira in 1991. As at the end of 1997, paid-up capital

The Nigerian banking system, prior to the introduction of the current have increased to 500 million naira and again increased to 2 billion in year

reforms, did not fully facilitate economic development as it was 2000. In 2001, the minimum paid-up capital for a new bank was raised form

characterized by a number of structural and operational inadequacies 1 billion naira to 2 billion naira and in June 2004, the Governor of CBN

(Soludo C. 2006). In one of his speech, he mentioned further that such announced that bank capitalization has been raised to 25 billion naira

inadequacies include, low capital base, a large number of small banks with effective from end of December 2005. This new capital base is

relatively few branches (89 banks with 3,382 branches), the dominance of a expected to inject sanity, maintain good health and protect the depositors

few banks (top 10 banks controlled about 51% of aggregate assets, 52% of against incessant bank failure in the economy. This, the policy makers felt

deposits and 45% of aggregate credits), poor rating by regulatory authorities would fully facilitate economic development and remove a number of

(as at December 2004, no Nigerian bank was rated very sound). structural and operational distortions. It is against this backdrop that this

The CBN in 1990 issued the circular on capital adequacy, which relate study seeks to provide additional evidence on the effects of the

bank’s capital requirements to risk-weighted assets. It directed the banks to recapitalization on the banking sector in developing country focusing on

maintain a minimum of 7.25 percent of risk-weighted assets as capital, hold Nigeria.

at least 50 percent of total components of capital in reserves and to maintain III. METHODOLOGY

the ratio of capital to total risk weighted assets at a minimum of 8 percent

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In choosing our econometric approach we were aware of the well-known bank’s specific effect, but a representation of what is happening at

problem of identifying supply-driven contractions in intermediation. This aggregate level shall be represented. We introduced a specific variable that

problem, noted among others by Bernanke and Lown (1991), Ghosh and capture the specific effects of uncertainties (see footnote No 7) on the

Ghosh and Ghosh (1999) and Peek and Rosengren (1995b), must be treated policy actions8, which government must not neglect, if she’s to follow the

within any attempt to empirically model interlink between bank balance implementation of her policies to the letter.

sheet and sources of its shocks. In view of this, the methodology we follow The model thus takes a lead from the works of previous authors

in our econometric analysis is the one proposed by Peek and Rosengren (Chiuri, et al. 2000 and Yudistira D. 2003) and as such specify as follows.

(1995). The peek and Rosengren framework can be easily generalized in ∆ BDt = a0 + a1BKt-1 + (a2 + a3BKt-1) x ∆ BKt + a4 log (At) +
At-1 At-1 At-1
order to model the effect that changes in capital regulation might caused on a5DRt + a6Yt + a7PFD + E1t ….. 1

deposits and loans of bank operating in Nigeria7. ∆ BLt = bo + b1BK t-1 + (b2 + b3BKt-1) x ∆ BKt + b4 log (At) +
At-1 At-1 At-1 At-1
The Model b b
5LRt + 6Yt + b7 PFD +E2t… 2
In order to test for the effect on deposits and loan of a change to capital

requirement, we use the Peek and Rosengren (1995) approach with some The dependent variable of equation (1) is the change in deposits (∆ BD)

modifications composed to specifically convene the Nigerian case. Though and of (2) is the change in loans (∆ BL). Both variables and change in bank

time series data were used but stationerity tests were conducted for the capital (∆ BK) are normalized by the beginning of the year of total assets

series used, haven’t realized the problem of trends that usually characterized (At-1) to reduce the potential heteroscedasity problems with the error term.

such data. However, we are aware that such data may not reveal individual Banks are not expected to fall below the minimum capital requirements;

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rather it is anticipated to adjust capital or assets to assets to satisfy the rate of GDP (y). Thus a5 and b5 are predicted to move positively
regulator. Banks with capital to asset ratio below the required minimum
(negatively) with changes in deposits (loans) whereas a6 and b6 are to be
would either have their licenses revolved or sense pressure to shrink
independent to the current capital shock. Thus, a bank with poor

capitalization is expected to have a sluggish growth in deposits or liabilities

The variable introduced to capture the extent of uncertainties (PFD)10 is
than better-capitalized institutions. To capture these phenomena, the tests
expected to have a negative shock on the policy targets. In vector error
include the beginning of the year capital to Asset ratio, with a1 and b1 are
correction (VEC) format equation 1 and 2 can be expressed as;
predicted to be positive 9. The a2 and b2 parameters define the effects of
∆ Yt = α 0Dt + α i∑∆ Yt-i - β iEcmt-1 - 3
change in bank deposits and change in bank loans to changes in bank capital
respectively and they were predicted to be positive.
Dt represents the deterministic component including intercept.

Yt is the vector of all variables as defined in equation 1 and 2 and the error
The effects of change in capital regulation on bank capital are smaller for
correction mechanism (ECM)11 shows the deviation of the dependent
banks with higher initial capital regulatory ratio and higher for poor
variable(s) from its long run path.
capitalized banks. As a result, parameters a3 and b3 are expected to be

negative. Also, the inclusion of logarithm of total assets (At) is to control for
Data Source and Measurement
bank’s size. Other factors that may be important in controlling demand
All data were obtained from Central Bank statistical bulletin (various
shocks are the deposit rate (DR) and lending rate (LR) as well as the growth
issues) covering 1970-2004. The total bank deposit include, time, savings
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and demand deposits. The GDP were expressed in growth rate while banks supported by the curiosity of significant positive finding in the growth of

total asset were in their logarithm form, we use E-view 3.0 econometric GDP as the benchmark for deposit rates in Nigeria.

package for analysis.

Empirical Results Parameters a3 in the regressions is significantly negative as predicted by the

Based on the models specified, we shall present the results of the estimates capital crunch hypothesis though, the coefficient obtained is large (0.98)

in two sections. The results of estimates of equation (1) which measures the indicating the characteristics of poor capitalized banks (see Chiuri et al

effects of capital regulation on bank deposits were reported in table 4.1 (2000) and Yudistira D. (2003). Logarithms of total asset also turn out with

based on OLS and VEC12 methods. The coefficient of the initial bank right sign (positive) and significant, which means, the size of banks have

capital requirement is strong and significant at 1 percent confidence level. positive influence on the change in deposits.

This result corroborates the result obtained by Yudistira D. (2003) for The bank deposit rates (DR) although positive but not-statistically

Indonesia. It implies that initial capital requirement clearly had significant significant. Due to either asymmetric information or high marginal

positive effects on bank deposits during the sample period. However, the propensity to consume of people, this variable may not be a significant

coefficient of ∆ BK/A shown a contrary sign (negative) and not statistically factor determining the volume of banks deposits. Political factor dummy,

significant. This is contrary to the results of Chiuri et al (2000). The result though Prove-insignificant but shows a tendency of negative relationship

may be due to the fact that, there are other factors that can determine change with bank behavior. The speed of adjustment of banks to equilibrium in

in deposits other than ∆ BK/A in such country like ours, this fact is volume of deposits as indicated by ECM is high (-0.96) and highly


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Constant -0.20 0.17

BK/A (-0.85) (5.49)*
∆ BK/A 0.50 0.68
BKx (3.38)* (1.77)***
∆ BK -2.28 -0.04
Table 4.1: Estimates of changes in Deposit A A (-0.82) (-0.41)
Log (A) -0.91 -0.002
Variables OLS VECM (-2.34)** (-1.93)*** * =1 % sig. Level
GDPg 0.01 0.02 ** = 5% sig level
PFD (0.82) (2.35)** *** = 10% sig level
∆ BDt-1 0.004 0.009
A t-1 (0.23)
0.71 (0.0565)
(-0.65) (236)**
- 0.004
R = 0.51
R2 = 0.49
DW = 0.28



R2 = 0.86
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Simulation Results
R2 = 0.80
We present the results of simulations base on variance-decomposition and
2.59E-08 impulse response 13 for change in deposits equation in table 4.2


1 34.8 65.1 1.3 0.00 0.00 0.00 0.00
(-1.04) (0.06) (0.00) (0.00) (0.00) (0.00) (0.00)
2 82.3 12.8 1.36 2.57 0.002 0.03 0.03
(0.16) (0.03) (-0.02) (0.04) (-0.003) (-0.003) (-0.003)
3. 56.2 8.3 10.4 5.8 10.5 8.2 0.13
(-0.04) (-0.008) (0.07) (-0.05) (0.073) (0.06) (0.002)
4 56.1 7.6 11.2 6.02 9.5 8.22 0.12
(0.06) (0.006 (0.04) (-0.02) (0.008) (0.012) (-0.007)
5. 59.7 7.7 10.13 5.3 8.2 7.5 0.25
(0.08) (-0.027) (-0.004) (-0.007) (-0.002) (-0.016) (-0.009)
6. 57.9 8.7 9.7 5.8 7.9 8.2 0.28
(0.04) (-0.03) (0.02) (-0.02) (0.014) (0.03) (-0.006)
7. 56.9 7.56 9.45 6.2 7.5 8.7 0.31
(0.04) (-0.03) (0.012) (-.02) (0.0003) (0.02) 0.005)
8. 57.4 10.4 8.95 5.8 7.29 8.3 0.31
(0.06) (-0.03) (-0.01 (-0.009) (-0.014) (0.013) (0.004)
9. 56.7 11.4 8.66 5.81 7.10 8.5 0.30
(0.04) (-0.035) (-0.007) -0.013) (0.008) (0.02) 0.009)
10. 56.0 12.1 8.53 5.82 7.08 8.6 0.29
0.02) (-0.026) -0.005) -0.013) (-0.010) (0.016) (0.005)
Source Authors Computation

The results above (table 4.2) demonstrate the effects of a shock in the initial

bank capital requirements (BKC) on the change in deposits and other

variables. Over the period horizon, the impulse response shows a negative

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dynamic multiplier (-1.04) on the change in deposit (BKD) in the first relationship with the change in loans also consistent with the results

period, the trend (negative) repeated itself in the third period, though, with obtained by Honda (2002) for Japanese bank and Chiuri et al (2000) for

lower multiplier (-0.04) before stabilizing itself to positive multipliers. some emerging countries. A change in capital variable came out with

Examining the shocks on bank capital, the result indicates more negative negative sign and proves to be insignificant in influencing change in loans

shocks (Period 3, 5, 6,7,8,9 and 10) than the positive ones. The policy in Nigeria.

implication of such a forecast is that, even with the shocks in initial bank

capital requirements, the multiplier effects on deposit is very low (ranges A negative relationship is found between parameter b3 and a change in

from –0.04 to 0.16). The variance decomposition also confirmed the same loans but highly significant contrary to the result obtained by Yudistira

results, with the growth of GDP assume a consistent positive percentage (2003). This indicates the possibilities of the banks to reduce their lending

rate over the time horizon, still confirming that the conditions in the in the aftermath of regulation. The logarithm of bank asset although turn out

economy strongly determines the behavior of banks in Nigeria. with positive sign but only prove significant using VEC method. This result

The results of estimates of equation (2), which investigates the effects of indicates that the size of bank can positively influence a change in loans in

bank regulation on bank loans, were reported in table 4.3. The result shows Nigeria. The lending rate and the variable used for political factor turn out

similar coefficients with what were obtained in deposits equation. GDP as to be positive but both not statistically significant in influencing a change in

the fundamental economic factor has a positive relationship with changes in loans in the country. The speed of adjustment (0.97) is faster than that of

loans, consistent with the result of Yudistira 2003 and Agung et al, (2001). deposits equation.

The capital regulation variable (parameter b1) show a significant positive

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Table 4.3: Estimates of Changes in Loans
Variables OLS VECM
Constant -0.35 0.24 R2 = 0.86
BK/A (-0.79) (3.93)
∆ BK/A 1.53 1.32 R2 = 0.80
BK x ∆ BK (3.24)* (1.85)***
DRC = 2.59E-08
A A -0.65 -0.49
We also present the results of our simulations for change in loans in table
Log (A) (-1.037) (-0.81)
LR -0.005 -0.006 4.4 below
∆ GDP (-2.83)** (-2.96)**
0.029 0.06 Table 4.4: Simulation Results of change in loans
∆ BL∆ t-1 (0.97) (1.99)***
A t-1 0.003 0.005 1 1.30 99.6 0.00 0.00 0.00 0.00 0.00
(0.15) (0.002) (0.04) (0.00) (0.00) (0.00) (0.00) (0.00)
ECM 2 83.2 12.6 1.35 3.64 0.008 0.08 0.17
0.04 (0-14)
(0.87) (0.03) (-0.009) (0.03) (-0.002) (-0.002) (-0.005)
(2.56)** 3. 42.8 21.2 0.16 13.62 0.013 3.08 17.48
0.02 (-0.06) (-0.09) (0.003) (0.08) (0.04) (0.041) (0.096)
4 37.2 26.3 1.49 13.94 0.46 3.26 15.96
(0.38) (2.74)** (-0.009) (0.07 (0.03) (-0.04) (0.02) (-0.019) (-0.023)
- 5. 42.6 24.1 1.79 12.04 0.43 3.617.5 13.96
(0.07) (-0.03) (-0.019) (-0.002) (-0.005) (-0.024) (-0.01)
- 0.04
6. 39.5 22.3 1.86 14.24 0.43 3.82 15.56
R = 0.55 (0.009) (0.006) (0.012) (-0.05) (-0.004) (0.019) (-0.04)
(0.57) 7. 36.7 21.8 2.24 16.5 0.40 3.61 16.24
R2 = 0.43
(0.02) (-0.03) (0.021) (-0.05) (0.003) (0.01) 0.04)
Dw = 2.17 8. 36.8 21.5 2.59 16.6 0.48 3.57 15.9
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(0.029) (-0.013) (0.018) (-0.02) (-0.009) (0.006) (0.007)

9. 36.2 21.3 2.64 17.04 0.58 3.58 15.9
(0.04) (-0.017) (-0.01) -0.03) (0.009) (0.09) (0.02)
10. 35.3 20.6 2.68 17.99 0.62 3.63 16.32
(-0.016) (0.06) (0.01) (-0.04) (-0.007) (0.012) (0.028)

The results in table 4.4 above show the effects of a shock in the

initial bank capital requirements (BKC) on the change in loans (BKL) and V. CONCLUSION AND POLICY IMPLICATIONS

other variables. The result indicates a negative shock in the second, third, This paper has provided new evidence on the effects that a stricter

fourth, seventh and tenth periods to a change in loans, with a very low enforcement of minimum capital discipline can have on bank intimidation

dynamic multipliers ranges from –0.009 (4th period) to 0, 87 (5th period) in Nigeria. In this respect, we have not limited our scope to the simple

using variance decomposition, the results of the growth of economic revision of capital ratios but have also carried out some simulations ahead

activity (GDP) in the 3rd, 4th and 5th periods of analysis indicates a variation of this period in which we discovered that the growth of economic activity

of 17.48, 15.96 and 13.96 percents respectively corresponding to variations determined more change in deposits as well as an improvement in loan

of 42.8, 37.2 and 42.6 percent in bank loans. The implication of these disbursement. Thus, capital regulation may not clearly address the distinct

results is that, the larger proportion of variation in bank loans is determined needs of our (Nigerian) economy. Based on our results some policy

by the growth of economic activity rather than some other endogenous lessons are prescribed.

variables of the banks. 1. It is clear that much remains to be done in the specific areas of

regulation and supervision. Nonetheless, it is important to ponder

the apparent relationship that emerged whereby the tightest

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regulations are not necessarily found in the best performing banking

systems. This may mean that strict regulations are important as the

banking system begins to develop, but it may be possible to relax

them somewhat in the long run, if and when banks begin to take

greater responsibility for their own behavior.

2. The best regulatory and supervisory system also assumes relatively

stable macroeconomic environment i.e. the environment must be

made stable.

3. Regulations should not be too tight as not to make the banks prefer

to hold only the safest assets, whether government bonds or loans to

the largest and lowest risk customers in the private sector.

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FOOTNOTE 9. The inclusion of lagged capital to asset ratios is also to mitigate the endogeneity

1. Being the result of merger and acquisitions embarked upon by various banks. problem (Chiuri et al 2001, Yudistira 2003).

2. The paragraph delved extensively on the literature review by Asogwa R.C (2005). 10. PDF is define as political factor dummy. This is choosing due to the past

3. Basically various autoressive method of forecasting is adopted. We followed steps experience of the country in its political realm

described in Charemza and Deadman (1992) see also maddala G.S. (2001). 11. If we denote the dependent variables by Z and the optimal level by Z*. If Z adjust
4. We realized that reforms in financial sector have to be implemented keeping in sluggishly to its optimal level Zx, i.e Z-Zt-1 = Y(Z* – Zt-1) with O < Y < 1, it
view not only the desirable direction but also the emerging uncertainties both in follows that Z = (1-y) Zt-1 + Yz*. The variable (ECM) is capturing the sluggishness
domestic and global arena. in the adjustment of BD and BL to its optimal level in an error correction
5. For the empirical works of the studies to investigate whether banks fulfil the mechanism
capital requirements see Jacques and Nigoo 91997); Calem and Rob (1996), 12. The results of unit root tests show a series that’s of integrated of different order.
Rime (2001) etc While the granger co integration tests reveal a stationary errors over time.
6. The term credit Crunch is the situation where the supply of loans is below the 13. Impulse response values for 10 periods horizon is shown below the variance
stipulated levels decomposition value (in bracket) due to space limitation
7. For details on the theoretical framework on banks’ balance sheet see; Chiuri et al

(2000) and Yudistira D. (2003). The two papers assumed a simplified balance

sheet of the form; Total Asset (A) = Loans (L) = Deposits (D) + bank capital (K)

i.e. A = L = D + K etc

8. Examples of uncertainties that can bewailed a reforms as stated in Asogwa R.C

(2005) includes domestic political crisis, military interventions and

macroeconomic volatility we use political factor dummy which assume 1 for

civilian government and zero otherwise.

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