RBI: Does regulatory capital influence banks credit and GDP?

RBI by release of its occasional research papers vide its communication dated June 11, 2021 analyses the role of regulatory bank capital in influencing credit flows and GDP growth with the following web release of ‘Macroeconomic Implifications of Bank Capital Regulations‘.

Analyzing the study in a layman’s language, the following questions have been raised in context of historical evidence around the world and also in India.

• Basel accord increased the role of regulatory capital in banks. Can the role of adequate bank capital in ensuring financial stability and mitigating losses from crises at global / Indian level be studied in depth?
• Can the focus be on the macro-financial implications of increased regulatory capital requirements?

The study undertaken by reputed researchers from RBI, namely, Ranajoy Guha Neogi and Harendra Beherais of 32 pages, incorporated in 8 sections as under:

• Introduction,
• Section II Bank Capital Environment in India
• Section III Review of Literature
• Section IV Theoretical Exposition, Proposition 1: No Free Lunch, Proposition 2: Hypothetical Free Lunch.
• Section V Data and Methodology, Table 1: Sign restrictions to identify the effects of bank capital shock, Table 2: Alternative Sign restrictions.
• Section VI Results (Chart 3: IRFs corresponding to exogenous one standard deviation bank capital shock, Chart 4: The Historical Decomposition, Chart 5: De-risking happens due to differential weights in RWA).
• Section VII Conclusion.

Those inclined to deal in depth about the above matter with lots of mathematical/statistical models knowledge and higher level of mathematical skills can read the above chapters and learn and appreciate the intellectual depths or brilliant ideas of the whole world or India.

My following explanations may suit an average banker/economist/student of academics, any management or professionals to enhance their awareness of our banking. A deeper study requires extensive knowledge of eco-statistics/higher mathematics and deeper understanding of economy.

(As an explanation for a common man, regulatory capital under Basel norms focuses on high-quality capital, predominantly in the form of shares and retained earnings that can absorb losses.)

The role of regulatory bank capital gained prominence in the Indian context from the days of the Basel Accord. Research on the role of adequate bank capital in ensuring financial stability and mitigating losses from future crises has gained further traction at a global level in the post-subprime crisis period. This refers to the reckless financing of housing sector by the Western world which brought the most famous big banks to their kneels and the governments intervened to save these too big banks to fail.

• Our focus in this paper is on the macro-financial implications of increased regulatory capital requirements.
• Before studying the above vexed issue, let us understand historically how did Indian banking encounter regulatory capital during the recent past. Always known to play safe without adhering to international stands of excellence, Basel framework evolved over the consistent failure of banks with no laid down norms for corporate governance and maintenance of capital with adequate credit risk exposures and sure way to get out of disasters.
• With the introduction of Basel 1 norms and its strict adherence by all commercial banks in 1988 necessitated the banks to maintain capital as a percentage of their credit risk exposures, and the financial stability required banks to include market risk, operational risk, and systematic risk.
• The Basel framework evolved over time since the introduction of Basel I norms in 1988 and thus necessitated banks to maintain capital as a percentage of their credit risk exposures. Subsequently, the risk coverage of the capital framework was expanded to include other risks on the banks’ balance sheet such as market risk and operational risk. In the post global financial crisis (GFC) period, systemic risk as a separate category also gained traction to address the risk of financial contagion.
• Clearly, credit risk has drawn the highest attention as an increase in defaults can abruptly lead to illiquidity and insolvency problems. Over time, the RBI has broadly moved as per the evolving frameworks of the BCBS to ensure financial stability.

Let us continue with our discussions on Basel norms further.

Capital regulation under Basel-III was further strengthened to increase the quantity and quality of capital, enhance the risk coverage and introduce macro prudential elements such as leverage ratio, countercyclical buffers and liquidity ratios. As against the international norms of 8 per cent CRAR, the Reserve Bank has stipulated banks in India to maintain a higher minimum CRAR of 9 per cent, in addition to capital conservation buffer (CCB) of 2.5 per cent and counter-cyclical capital buffer. This clearly explains the importance given by RBI for CRAR.

 Banks in India had to maintain CCB of 2.5 per cent by March 31, 2019 in tranches of 0.625 percentage points, which was deferred to March 31, 2020. Considering the potential stress on account of COVID-19, the Reserve Bank further deferred the implementation of the last tranche of 0.625 per cent of the CCB from March 31, 2020 to September 30, 2020 and subsequently to April 01, 2021. It has been further deferred to October 1, 2021. This is clearly understandable with the COVID 19 ramifications on Indian economy and the failure of commercial banks to function regularly.

India being a bank dominated economy, capital regulation has a major role to ensure financial stability. Due to the rise in stressed assets of banks in India, maintaining capital adequacy becomes critical.

Our further discussion has been drawn from page 5 Chart 1: Relationship between Bank Capital and Costs.

What are conclusions from study of above chart?

Researchers Muduli and Behera (2020) found that an increase of CRAR is expected to result in better economy by enhancing credit supply. More loans are given by banks due to their improved financial health and resultant reduced cost of borrowing. Yes, all due to the higher CRAR.

To understand further, let us refer to the chart from page 5 again. The chart shows that the cost of borrowing declined with rise in capital of banks in India. Similarly, lending rate of banks was also found to be lower for banks with higher capital ratios.

It can be seen that an increase in the capital position of banks helped them to not only access funds at cheaper costs but also increase credit as they reduced their lending rate.

Review of past literature

I would like to quote a para from main research paper to introduce you to the maze of research papers which emerged to juxtapose the theory of researchers.

“The literature on bank capital shock posits that an exogenous rise in regulatory capital requirement causes a fall in credit supply. This is because the rise in capital requirement leads banks to rebalance their portfolio towards secured assets as they gradually increase their capital levels.

 On the contrary, the ‘macroprudential’ literature dealing with bank level data finds a strong positive effect on credit supply from a rise in equity component in bank’s balance sheet.”

(Catalán et al. 2017; Gambacorta and Shin 2018; Cantú et al. 2019; Muduli and Behera, 2020).

Other literature quoted is given below with the optimistic note that many among you do care to read the research papers to enhance the knowledge horizon.

• (Fang et al. 2018; Budnik et al. 2019)
• (Bernanke and Lown, 1991; Hancock et al. 1995; Peek and Rosengren, 1997; Watanabe, 2007; Mora and Logan, 2012; Liu and Molise, 2019); a few researchers separated regulatory shocks to bank capital as bank-level shock from system-wide shock (Peek and Rosengren, 1995; Woo, 2003; Francis and Osborne, 2009; Aiyar et al. 2012; Bridges et al. 2014; Jimenez et al. 2017; Mesonnier and Monks, 2015; Maurin and Toivanen, 2012).

What about literature on India?

• In the Indian context, there are only a few studies that examine the effects of bank capital shock. Ghosh and Das (2005) point out in the Indian context that higher capital adequacy significantly brings down the borrowing cost of the banks. Similarly, in a related study, Das and Ghosh (2006) shows that the financially sound banks are more efficient and have less non-performing loans; Ghosh (2008) and Nachane et al. (2006) found that the effectiveness of monetary policy to influence lending depends on the capital position of banks.
• A more direct approach to study the implications of bank capital (RBI, 2019) shows that higher bank capital raises credit supply. Using bank level data for the period 2008-18, Verma and Herwardkar (2019) shows that the relationship between bank capital and credit growth is positive and non-linear.
• Muduli and Behera (2020) found that higher equity to total asset ratio reduces the cost of funding and thereby increases credit supply. These findings are similar to the evidences provided by Gambacorta et al. (2018) and Bridges et al. (2014) who showed that the cost of external financing of bank’s borrowing reduces with increases in their capital adequacy, which in turn increases credit supply.

Can we sum up the conclusions?

To sum up the findings from the literature, the bank capital shock can have beneficial effects; however, the isolation of bank capital shock from other shocks is important to observe this effect.

I completely omit section IV Theoretical Exposition from our discussion which is totally theoretical requiring a higher level of mathematical calculations. A serious minded one can refer at page 9 of the web site quoted above.

Section V, data and methodology

For empirical estimation, the researchers used quarterly data of the relevant macro-financial variables for the period 2009-10: Q1 to 2017-18: Q4. The variables used were real GDP, consumer price index (CPI), policy repo rate, real non-food bank credit (RNFBC, henceforth), spread (calculated by taking the difference between weighted average lending rate and repo rate), and CRAR.

The RNFBC was derived by deflating nominal non-food bank credit with CPI. Real GDP, CPI and non-food bank credit were transformed into seasonally adjusted annualized growth form while repo rate was expressed in first difference form.

Let us look at the conclusions arrived at by the researchers.

• The researchers examined the role of bank capital in boosting credit supply and GDP growth. They showed that the overall borrowing cost of banks fell in response to a rise in regulatory capital requirement even under a zero MM offset if the cost of debt financing was elastic to leverage. The fall in cost of capital, thus, reduced lending spread and augmented credit supply.
• The Bayesian impulse responses and historical decomposition results also confirmed the positive effect of bank capital on loan supply and GDP growth.
• Regulatory bank capital shock in the Indian context rendered a positive credit-led push to GDP growth by strengthening the balance sheets of banks and the consequent reduction of their overall cost of borrowings.
• Under a regulatory capital shock, banks readjusted their risky loans and shifted towards assets that carried lesser risk weights that ultimately raised aggregate credit flows.

Our conclusion

The purpose of this article is to draw the effects of increase in regulatory capital in banks and the resultant effect on their credit and ultimately on the GDP growth of our nation.

I hope, I could simply explain the effect of regulatory capital influx in our banking system growth, particularly on credit growth and GDP growth, otherwise on the economy.

However, a future research question to explore would be to further identify the exact transmission channel(s) of a bank capital shock impacting lending spread or credit supply.

I firmly believe that frequent exposure of our knowledge to various studies of world class standard from RBI would force us to seriously think before investing our funds, appreciate the greater efforts of our researchers to enhance our economic horizon and ultimately enable our nation to emerge among the developed nations. Let us appreciate our brilliant researchers from RBI for their outstanding research skills of world class standard.

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