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Capital

whetherrequirement and financial


argument, there is also a question about
the capital regulations have any

regulations in maybanking:
unintended effects. The imposition of
capital requirements have adverse Are they
effective?
effects on some banking firms or at least
the capital-deficient banks. Capital-
Dr Rubi Ahmaddeficient banks will be forced to alter
Lecturer, Department of Finance
their capital and Banking,
structure Faculty
and the of Business and Accountancy, University of
change
Malaya
may result in an adverse wealth effect
ABSTRACT This forarticle
the banks’
describesequity
the holders if the and
role of capital fi rms
capital requirement in the
were previously operating at or near
banking industry. Using an accounting defi nition, bank capital refers to common stocks,
their optimal
surplus and undistributed profi structure (Eyssellamong
ts. This capital, & other things, acts as a cushion or
buffer to absorbArshadi,
unexpected1990). There
losses. are these
When otherslosses
who exceed this buffer amount, bank
claimathat
failure occurs. Since risk-based
single bank failurecapital
may prove contagious as observed in the 1997
Asian fi nancial requirements would
crisis, bank capital lead toshould
position a credit
not be allowed to erode. Because of
this, regulators crunch
regulateandtheeven
level postulate
of capital in that
thethe Basleinstitutions. Hence, regulatory
banking
capital refers toAccord had played
the minimum amount a role in thecapital
of equity US credit
that banks must maintain to
crunch of
comply with regulatory the 1980s that
requirements. Bank led to economic
capital and default, however, are not always
inversely relateddownturns.
as proven in past studies. Accordingly, this article also explains why a
stringent capital requirement does not necessary reduce the probability of bank failure.
Like other forms of regulations, the announcement of new capital requirements can have
both good and bad effects on the targeted fi nancial institutions and markets. Capital
requirements create pressure on the targeted fi nancial institutions: in this case there is
pressure to maintain higher capital ratios and to hold a higher percentage of equity
capital per loan than per government security. As loans are riskier than securities, bank
risk-taking presumably falls as banks shift their portfolios away from loans and into
securities. Increasing capital requirements can result in increasing rather than reducing
bank risk. Instead of switching to less risky assets, capital requirements can motivate
banks to take greater risk by holding more risky assets. Evidently, there is no guarantee
that capital requirements will lead to greater stability and wealth for banks.
LACK OF CAPITAL has often been cited as a major cause of bank failures. Subsequently,
banking supervisors around the world impose capital regulations based on the
recommendations by the Basle Committee. In 1988, the Basle Committee, represented by
the G-10 countries, agreed on a common framework of capital adequacy measurement,
i.e. an 8% minimum target risk-based capital standard (CAR) for banks operating
internationally. In 1999, the Committee issued a proposal for a new Basel Capital Accord
to replace the Basle I Accord. The format of the Basle II Accord has now been finalised but
will not be fully adopted until 2007/2008. While the present 1988 Basle I Accord
incorporates the use of models for measuring credit and market risks, the new risk-based
capital plan will explicitly contain, for the first time, a measurement of operational risk.
Other changes include requirements for supervisory review and market discipline.
Malaysia will be adopting the Basle II Capital Accord.
The emphasis on risk-based capital requirements as a tool to promote greater fi nancial
stability is based on the notion that the higher the capital, the safer is the bank. In other
words, bank capital acts as a cushion against bank failures. Some economists, however,
argue that while capital requirements may have boosted capital-asset ratios, they have
failed to prevent an increase in the overall risk of the banking industry. This implies that
stringent capital requirements may, in fact, result in a rise in bank risk-taking. The
discussion on the relationship between capital requirements and bank risk-taking is not a
trivial issue. Indeed, understanding the impact of capital requirements on bank behaviour
is important and the new proposal on the Basle Accord even makes it obligatory. The
following paragraphs provide further insight into their effects on the behaviour of the
regulated banks and the reasons why such regulations exist in the fi rst place.

THE REGULATORY FRAMEWORK


There is already an extensive and well-established body of banking literature on the
impact and effectiveness of financial regulations, including bank capital
requirements on controlling bank risk. Most of these studies cover US banks and
banks of other developed countries. Both in the empirical and theoretical literature,
the conclusions provided are mixed. Some results suggest that capital requirements
fail to limit risk-taking by banks while others support the claim that capital
regulations act as an insurance against bank crises. At the heart of this
ffd8ffe0001
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494343
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2007ce00020
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00006163737
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04d53465400
010000
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32073524742
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00000000000
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00100000000
6d6e747
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252474
00000000000
220585
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95a2007
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600310
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000616
00000001163
373704
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15000000033
d53465
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400000
00184000000
000494
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00001f00000
543207
0014626b707
352474
40000020400
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00001472585
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d60001
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485020
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200000
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116370
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000150
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000000
00006465736
336465
30000000000
736300
00001273524
74220494543
000184
36313936362
000000
ffd8ffe000
ffd8ffe00
104a46494
0104a464
600010201
94600010
00c800c800
00ffe20c58
20100c80
4943435f50
0c80000ff
524f46494c
450001010
e20c5849
0000c484c6
43435f50
96e6f02100
524f4649
0006d6e74 costs. When new regulations are imposed, the regulated banks
725247422 experience a rise in their compliance costs while the regulators’ direct
4c450001
058595a20
costs rise too. The bank regulators have to redesign existing regulations,
re-train and increase their staff workload, arrange visits to banks and

0100000c
07ce000200 organise workshops on the proposed regulations. At the same time, a
successful implementation of capital requirements requires the
090006003
484c696e
regulators’ fi rm commitment and good supervision. However, the
likelihood of capital regulations achieving their stated goals greatly
100006163 depends on the manner and stringency with which regulatory bodies
6f021000
73704d534 enforce regulatory requirements.

006d6e74
654000000
004945432
72524742
073524742
2058595a
000000000
000000000
2007ce00
000000000
02000900
0f6d600010
0000000d3
06003100
2d4850202
00616373
000000000
704d5346
000000000
MORE OR LESS
000000000
54000000
000000000 REGULATION: WHICH IS
Over the last 2 decades, the Malaysian BETTER?
00494543
000000000 Given the uncertainty over the banks’
central bank has introduced many changes reaction to new financial regulations and
000000000
20735247
000000000to the country’s financial regulations based on the experience in some countries,
42000000
000000000including those covering capital tightening rather than loosening regulatory
requirements. The capital requirements
00000000
000000000
imposed took two major forms. Besides the comments can be made on developed
restrictions is not necessarily better. Similar
000000000
00000000
000001163mandatory risk-weighted capital adequacy versus less developed banking systems:
000000f6
707274000ratio in 1989, a two-tier regulatory system highly ‘developed’ banking systems are not
001500000was also introduced in the mid-1990s. necessarily less prone to crisis than less
d6000100
003364657According to Bank Negara Malaysia, these ‘developed’ systems. The thrift industry
000000d3
363000001regulations were aimed at creating local crisis in the US in the late 1980s is a good
2d485020bank
840000006 and non-bank fi nancial institutions example. Another case is Japan, which has
with a strong capital base, a strong asset suffered many years of banking crises
c77747074
20000000 base and effi cient operations. There is a caused by bad loans and business
000001f000
00000000
000014626lack of empirical studies to show that decisions. Banking crises are indeed
b70740000capital regulations have actually increased common
00000000
020400000the local banks’ fi nancial stability and countries – the Mexican banking crisis in
phenomena in developing
00000000
014725859soundness. However, we do know, to some the early 1990s and, more recently, the
5a0000021
00000000 extent, that the previous regulations, in 1997 Asian fi nancial crisis.
800000014general, have been unsuccessful in
00000000
6758595a0insulating our financial system from On the one hand, it may be agreed that
00000000
000022c00external shocks such as the devaluation of there is a higher probability of banks
000014625the Thai baht and the ensuing Asian suffering crises when there are fewer
00000000
8595a0000financial crisis. As it turned out, the rather than more regulations, although,
00000000
024000000country’s fi nancial sector proved very whether the former is better than the latter
014646d6e as is moot. Some countries gain a lot from
00000000
640000025
vulnerable to external shocks
experienced in the late 1990s. We could, having a less restrictive regulatory system
00000000
400000070therefore, conclude that the risk level of while others suffer greater instability. For
00000000
646d64640Malaysian banks had actually deteriorated the last two decades, national bank
00002c400in the 1990s despite the implementation of regulatory and supervisory authorities
11637072
000088767the risk-based capital requirements in l992. around the world have often been criticised
74000001
565640000Most importantly, the previous regulatory for committing to either an over- or under-
034c00000
50000000
086766965
changes on bank capital had failed to regulated environment. There is a view
encourage the under-capitalised banks, in among academicians that regulators create
33646573
77000003d
particular, (refer to those with capital ratios an unnecessary regulatory burden for the
400000024
63000001 belowthe impact
the on industry average)
institutions,to more banking
be regulation industry; many regulations
6c756d6900
Besides regulated fi nancial any new
represent a deadweight economic loss,
84000000 prudent.
imposed
0003f80000
affects1the regulatory bodies that supervise and control bank
operations. To the bankers, capital requirements, for example, impose an
wasting resources without measurable
unnecessary burden that translates to higher
6c777470
00146d656 benefits to safety and soundness (Benston
173000004
74000001
0c0000002
& Kaufman, 1996). Undoubtedly, there is a
tendency towards over-regulation given
f0000000
474656368
that regulation is not usually supplied
000004300
14626b70
000000c72
through
74000002
5452430001 A recent study by Ahmad, Ariff and Skully (2004) suggest that the observed increase in
equity-to-asset ratios of Malaysian banks during the period 1995-2002 is unrelated to the
04000000stringent regulatory standards
0043c0000
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000043c00
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578740000
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0000436f70
2c000000
797269676
14625859
874202863
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000104a
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000102
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0100c80
00010100000
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0c80000
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74725247422
a market mechanism. Public pressure can – particularly a large commercial bank - 494343
058595a2007
ce000200090
encourage regulators to impose too many can have detrimental consequences for the 5f50524
00600310000
regulations, perhaps because bank whole economy. Even with the growth of f46494c
616373704d5
customers treat regulation as a free good. the mutual funds and pension funds, 34654000000
In contrast, some policy makers, commercial banks remain the kingpins of 450001
00494543207
academicians and professionals have every fi nancial system (Sinkey, 1998). 010000
35247420000
criticised some countries’ bank regulatory Banks are exposed to, among other things,
and supervisory authorities for not credit and liquidity risk. While the former
0c484c6
00000000000
00000000000
controlling their banks stringently. For refers to the possibility of the borrowers 96e6f02
00f6d6000100
example, the low capital requirement has defaulting on loan repayments, the latter 100000
000000d32d4
been cited as a potential flaw in the current refers to banks not having enough cash to 85020200000
design of bank capital regulation (Furfi ne, meet deposit withdrawals. The riskier a 6d6e747
00000000000
2000). According to Llewellyn (2000), weak bank’s assets (i.e. the higher the ratio of 252474
00000000000
regulations, poor supervision and loans to total assets), the more vulnerable 00000000000
220585
inadequate information disclosure are the bank is likely to be. A country cannot 00000000000
examples of the major causes of the afford to suffer from bank failures as they 95a2007
00000000000
developing countries’ banking crises. The are contagious and must be contained to ce00020
00000000000
prevent the collapse of the whole banking 00000000000
problem could also be due to poor
enforcement of fi nancial regulations by the
system. The banking system’s collapse can 009000
00000000000
result in severe economic crisis as seen in 600310
00116370727
regulatory bodies. It is suffice to say that
the recent Asian crisis that hit Indonesia, 40000015000
regulatory bodies in these countries are
Malaysia, South Korea and Thailand. 000616
00003364657
less independent than their counterparts in
developed countries. The performance of 373704
36300000184
Hence, every government attempts to
regulatory bodies does matter, to some
prevent bank failures and gives bank
d53465
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extent, in managing the risk levels and 47074000001f
soundness of banking systems.
regulators the responsibility to ensure that 400000
00000001462
WHY WE NEED TO REGULATE THE BANKS the banks are safe. Bank regulators are 000494
6b707400000
There are several reasons why financial presumed to impose regulations to force or 20400000014
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institutions and financial markets are coerce banks and other financial 7258595a000
subject to extensive regulations. Bankers, institutions to lessen their risk exposure. 352474
00218000000
Some form of regulations is undoubtedly 146758595a0
insurers, stockbrokers and fund managers 200000
collect funds from their clients and these required. At the same time, there is a view 000022c0000
funds are either lent out to other clients or among academicians that in some financial 000000
00146258595
invested in financial assets. Their clients systems the majority of regulations may 000000
a0000024000
not be useful and could be eliminated. 000014646d6
vary from informed to uninformed 000000
investors. The majority of these investors Academicians thus disagree on the way e6400000254
rely on information these financial these markets and institutions should be 00000f6
00000070646
intermediaries provide. Hence, investors regulated rather than on the existence of d6464000002
d60001
the regulations per se. c4000000887
have imperfect knowledge about the price 000000
67565640000
and riskiness of the products invested in by THE DIFFERENT FORMS OF REGULATIONS
the various financial institutions. The 00d32d
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Financial regulations come in various forms 67669657700
problem that arises from having poor price
and are usually grouped under either 485020
0003d400000
and product information and also from
informational symmetries between the
prudential or protective regulation. While 200000
0246c756d69
the former is used to limit competition and 000003f80000
suppliers and users of financial services
avoid bank failures, the latter is imposed to
000000
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justify the need for financial regulation
protect banks against the consequences of 000000
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(Saunders, 2000). Banks are subject to
moral hazard and adverse selection and
bank failures. Examples of protective 000000
00002474656
regulation are deposit insurance, minimum 36800000430
thus they must be monitored. However,
capital requirements and restrictions on
000000
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monitoring is costly and requires access to 000000
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market entry. In the case of prudential
information. Since depositors are small and 3c0000080c6
regulations, the most common instruments 000000
uninformed investors, they are not in the 75452430000
used are liquidity requirements, credit
position to monitor the banks. They need a
limits, risk management systems, interest 000000
043c0000080
regulator to monitor the banks on their c6254524300
behalf.
rate controls and maximum loan 000000
Another reason used to justify financial concentration requirements. In the case of 00043c00000
regulation is that the financial sector is one protective regulations, regulatory bodies
000000
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of the most important sectors in any prefer capital adequacy requirements as an 000000
00000000436f
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country. The performance of other sectors instrument of control, believing that low 000000
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may depend heavily on the fi nancial capital is a frequent reason for bank
system’s efficiency and stability. Financial failures. Hence, capital adequacy regulation 000000
20313939382
04865776c65
regulations are used to ensure that banks is the most widely used and internationally 000000
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and other financial institutions are fi accepted means to discipline banks. It is
nancially sound. The collapse of one
000000
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used to reduce the risk of systemic failures.
financial institution 000000
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00000012735
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000150
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000000
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00000000000
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00000000012
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000184
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000000
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0104a464
94600010
20100c80
0c80000ff
e20c5849
43435f50
524f4649Before the 1980s, capital requirements in latest framework bears a strong
4c450001most countries took the form of minimum relationship to total bank risk.
0100000ccapital-asset ratios that were independent
of risk. When these failed to prevent an
484c696eincrease in overall risk in the banking IMPACT OF CAPITAL REGULATION
6f021000industry, bank regulators in developed Capital regulation is viewed as a tax on the
regulated institutions or its customers. The
006d6e74countries felt that capital requirements
would be better able to contain bank risk if use of differential weighting shows that it is
72524742the requirements were based on the a form of differential tax with the intention
to encourage low risk category activities at
2058595ariskiness of each bank’s activities. For that the expense of high ones, to segment fi
reason, the Basle Committee, which
2007ce00consisted of banking officials from 12 nancial markets and to alter interest
02000900industrial countries, fi nally agreed in 1988 differentials between alternative forms of fi
nancing (Hogan & Sharpe, 1990). There
06003100on a common framework of capital
must obviously be an appropriate
adequacy measurement and a common
00616373minimum target risk-based capital standard assessment of risk to avoid market
704d5346for banks operating internationally. The distortions.

540000001988 risk-adjusted capital requirements


recommended by the Committee
Risk-based capital requirements, in theory,
should improve control over risk-taking by
00494543incorporated the measurements of credit reducing risky banks’ chances of failing
20735247risks. It was no surprise that some without driving up safe banks’ cost of funds
academicians criticised the new framework by rewarding banks for shifting to safer
42000000claiming that it was a misleading indicator activities and by discouraging risky banks
00000000of capital adequacy as it contained many from outgrowing safe banks (Keeton,
00000000defi ciencies particularly in relation to risk
management procedures and concepts
1992). The whole idea behind risk-based
requirements is to force risky banks to hold
000000f6(Hogan & Sharpe, 1990). This 1988 more capital and fewer deposits or shift to
d6000100framework was designed to strengthen the safer activities like investing more in
000000d3soundness of the international banking
system by relating capital requirements
government securities instead of loans.
With risk-based requirements, market
2d485020exclusively to credit risk, which indicated participants perceive capital-defi cient
20000000the absence of a comprehensive portfolio banks as risky banks and, hence, the cost
approach to risk assessment. Besides of funds for risky banks will be higher than
00000000ignoring other risks that banks faced, the that for safe banks. This induces risky
00000000framework also failed to provide a good banks to grow slower and safe banks faster.
00000000indicator of total bank risk because it relied
heavily on the historical-cost accounting
On the other hand, the minimum capital
requirement can motivate banks to replace
00000000technique (Hogan & Sharpe, 1990). It was low risk assets with higher yielding, riskier
00000000claimed that the proposed initial framework assets. This is most certainly true for banks
was somewhat spurious as a measure of that strive to maximise the banks’ value
00000000Another
risk.
alleged shortcoming of the Basle I
Accord is that it ignores operational risk. (Kahane, 1977). In his study, Kahane
00000000Operational risk refers to risks connected to (1977) shows that capital requirements are
00000000banking operations such as loss from not always effective in lowering the bank’s
probability of failure. Under certain
00000000computer failures, poor documentation and circumstances, capital requirements may
fraud. In 1996, the Basle I was extended to
00000000include only the use of models for motivate banks to take greater risks by
00000000measuring market risks but still discounting holding more risky assets.

11637072operational risks. For regulators, then, the


framework for measurement of operational
Capital requirements, therefore, affect
bank risk and value in many ways. As
74000001risks was not as important as the other two described earlier, capital requirements are
50000000risks. Today, many regulators take a intended to influence banks’ capital ratios,
different view. With the on-going particularly where a bank is thought to be
33646573transformation of the banking business, risk undercapitalised. The imposition of a
63000001management practices, supervisory minimum capital requirement is intended
84000000approaches and financial markets, a more to force such a bank to adjust its balance
risk-sensitive framework is required that sheet to comply with the new requirement.
6c777470places more emphasis on the banks’ own The affected banks have to decide whether
74000001internal control and management,
supervisory review process and market
to raise more capital, (holding assets
constant) or to reduce risk-weighted assets,
f0000000discipline (BIS 2001). The newly (holding capital constant). For example,
14626b70recommended Basle II Accord explicitly risk-weighted assets can be reduced by
contains, for the first time, a measurement
74000002of operational risk as well as an improved selling assets and using the proceeds to
retire liabilities, switching from higher- to
04000000measurement of credit risks. In a way, the lower-weighted assets or
14725859
5a000002
18000000
14675859
5a000002
2c000000
14625859
5a000002
engaging in capital arbitrage practices
such as securitisation (Basle Committee
Report 1999). Capital, on the other hand,
can be increased by either issuing
additional equity or by increasing earnings
retention. Banks can also raise their capital
ratios over time
ffd8ffe000
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840000006
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000004300
000000c72
545243000
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0000436f70
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