**Trade-offs between Real Economic Acti****vity and Bank Profitability for** **Implementing New Regulatory Standards: South Asian Perspective**

**Ripon Roy*****Rokeya Khatun***

*Abstract*

*To ensure financial stability and more resilient banks, new capital requirements are introduced through Basel II along with a strengthened common equity buffer. These tighter capital requirements are expected to have negative effects on the level of long run steady-state output but also an estimated positive benefit by reducing the probability of banking crises and the associated banking losses, thus, inducing their profitability. In our paper, we want to focus on the long run effects on GDP and bank profitability in South Asia due to changes in banking regulation particularly through stronger capital requirements.*

**JEL classification:** E52 (Monetary Policy), E58 (Central Banks and Their policies).

**Key words:** Trade-offs, Basel II, equity buffer, capital and liquidity requirements.

*The authors are Deputy Director and Deputy General Manager, Governor Secretariat, Bangladesh Bank. The views expressed in the paper are authors’ own and do not reflect that of the Bangladesh Bank.

**Table of contents**

**Introduction**

The banking sector of South Asia generally proved resilient during the Global Financial Crisis in 2008. This development was achieved due to the implementation of stringent regulatory and supervisory standards within a stable, sounder and more flexible macroeconomic management framework over the past decade. Stringent capital ratios reduce the probability of systematic banking crises and smaller output volatility, thereby leading to welfare gains. In this paper we specifically focus on the economic benefits of higher capital levels associated with a reduced probability of systematic banking crises while the output volatility is omitted for data limitations.

The paper is organized in the following way. It starts with reviewing the existing literature on the economic benefits and costs of implementing tighter regulatory standards particularly coming through Basel accords. This is followed by Section 3 which captures the estimation of the economic benefits of tightened capital ratios. The next section estimates the economic costs of tightened capital ratios due to a rise in lending rate. Section 5 calculates the net benefits of the new regulation through comparing the results of Section 3 and Section 4. The final section includes the conclusions and policy implications.

Some Stylized Facts

**Literature review**

The economic benefits of stringent capital and liquidity regulations are mainly reflected in the literature through a more robust banking sector which is less prone to crises while the costs are reflected through a reduction in output. Existing literature on the issue can be categorized in three sections: the impact of capital and liquidity requirements on the probability of banking crises occurring (see, Barrell et al., 2009; Kato et al., 2010; Wong et al., 2010; Gauthier et al., 2010; Caggiano & Calice, 2011; Miles et al., 2013 and Yan et al., 2012), expected GDP loss associated with a banking crisis (see, Hutchison & Noy, 2005; Demirgüç-Kunt et al., 2006; Laeven & Valencia, 2010, 2013; Turrini et al., 2011; Furceri & Zdzienicka, 2012 and Kapp & Vega, 2014) and economic costs due to arise in lending cost (see, Basel Committee on Banking Supervision, 2010; Wong et al., 2010; Gambacorta, 2011; Caggiano & Calice, 2011; Turrini et al., 2011 and Miles et al., 2013).

Barrell et al. (2009) and Kato et al. (2010) build reduced form probit models for investigating the statistical relationship of probability of crisis occuring with bank capital and liquidity. Wong et al. (2010) used a cost-benfit analysis approach to assess the impact of tightened capital ratios for Hong Kong. By using a probit model for estimating banking crises and vector error correction models (VECM) for estimating long term output reduction, they concluded that regulatory reforms would bring a net long term gain for Hong Kong economy. The Bank of Canada (2010) did a similar cost-benfit analysis approach for Canadian economy and depicted that the net gain of incresing the bank capital ratio by 2 percentage points will amount to 0.8 percent of GDP. Gambacorta (2011) alsoused a VECM approach to evaluate the new regulatory standards for the US economy over the period 1994-2008. They found that the estimated positive benefit of reforms through reducing the probability of banking crises and associated banking loss overrun the negative effects on the level of output. However, these approaches are subject to Lucas critique for not allowing counterfactual experiments.

Our academic experts are ready and waiting to assist with any writing project you may have. From simple essay plans, through to full dissertations, you can guarantee we have a service perfectly matched to your needs.

Using aggregate and bank-level panel data sets, Hutchison & Noy (2005) and Demirgüç-Kunt et al. (2006) measured the temporary GDP loss. To do that they took the peak point of pre-crisis period growth rate and continued till that growth is retrieved. Laeven & Valencia (2010, 2013) calculated the temporary cumulative GDP loss taking the peak to trough output loss of output through the period of a banking crisis. Furceri & Zdzienicka (2012) calculated the permanent GDP loss using an unbalanced panel of 159 countries over the period 1970 to 2006. They concluded about significant output losses which are relatively higher in richer economies given their higher level of financial deepening and larger current account imbalances.

Turrini et al. (2011) used a dynamic stocastic general equilibrium (DSGE) model with a banking sector and financial frictions to calibrate the changes in spreads, lending and output due to changes in capital and liquidity requirements. The advantage of this model over the VECM analysia is that it allows counterfactual policy experiments in a consistent conceptual framework. Some other studies using DSGE framework are Van den Heuvel (2008) and Meh & Moran (2010). Using US data, Van den Heuvel (2008) found that the welfare cost of current capital adequacy regulation is equivalent to a permanent loss in consumption of between 0.1% and 1%. Meh & Moran (2010) also concluded that bank capital shocks create sizeable declines in output and investment.

Miles et al. (2013) used an assumed probability distribution to estimate the long-run costs and benefits of having banks fund more of their assets with loss-absorbing capital, or equity. They estimated the changes in economic activity described by a production function with constant elasticity of substitution due to a capital effect via an increase in the banks’ weighted average cost of capital.

By using a series of models, Basel Committee on Banking Supervision (2010) found that capital and liqudity reforms attain net benefits range from 0.68 percent to 1.90 percent of GDP for advanced economies. Caggiano & Calice (2011) examined the impact of higher capital ratios on the probability of banking crises and aggregate output in a comprehensive panel of African Economies. While they quantified the econommic benfits in terms of lower probability of banking crises using a multivariate logit model, economic costs are quantified in terms of lower economic growth due to higher cost of lending using two-step fixed effect panel data models. They concluded that the stringent regulatory standards might lead to long term net welfare gains to African economies.

There is no other study investigating the macroeconomic impacts of new regulatory capital accords for the South Asian countries as per the best of our knowledge. Our work on the issue, thus, will contribute to fill the gap. In our paper we have mainly tried to focus on the benefits and costs of stringent capital ratios rather than estimate the optimal capital requirement for South Asian economies. The estimation of the model is done using annual data over the period 1996-2013 for five South Asian countries which are Bangladesh, India, Nepal, Pakistan and Sri Lanka. The other three countries (Afghanistan, Bhutan and Maldives) are excluded for lack of sufficient data.

**Estimating the economic benefits of tightened capital ratios***The impact of capital ratios on the probability of crises occurring*

A multivariate panel logit model is used to estimate the impact of tighter capital requirements on bank crises. The model is widely used in the empirical literature on the causes of banking crises since its inception by Demirguc-Kunt & Detragiache (1998). In the model the probability of banking crisis is assumed to be a function of a set of potential explanatory variables. Given the hypothesized functional form, typically linear, the estimated logit gives the estimated probability of crisis. The dependent variable probability of banking crisis is a binary variable which takes a value of 1 if country i is hit by a crisis at time t and 0 otherwise.

where represents a set of macroeconomic variables including capital adequacy ratio, real interest rate, private sector credit to GDP as well as growth of GDP deflator, GDP, current account balance, terms of trade and credit. The set of the explanatory variables are chosen following other recent works in the subject, particularly Demirgüç-Kunt et al. (2006), Barrell et al. (2009), Wong et al. (2010) and Caggiano & Calice (2011). be the vector of k parameters to be estimated and É¸ the cumulative probability density function which is assumed here to be logistic. The log-likelihood function of the model that must be maximized is:

We have followed the conventional and widely used definition of banking crises suggested by Demirguc-Kunt & Detragiache (1998). According to them banking crisis occurs when the banking sector’s non perfoming loan ratiio exceeds 10 percent. We have taken a general-to-specific approach by progressively reducing the general model with including only those explanatory variables that are statistically significant at 1%, 5% and 10% level, as done by Caggiano & Calice (2011).