The Impact of Capital Adequacy Requirements on Performance of Scheduled Commercial Banks

By Vyas, R. K.; Singh, Manmeet et al. | Asia-Pacific Business Review, April-June 2008 | Go to article overview

The Impact of Capital Adequacy Requirements on Performance of Scheduled Commercial Banks


Vyas, R. K., Singh, Manmeet, Yadav, Ravindra, Asia-Pacific Business Review


Introduction

Financial Sector Reforms set in motion in 1991 have greatly changed the face of Indian Banking Sector. Banking Industry has moved gradually from a regulated environment to a deregulated market economy. Liberalization has pushed banks into new areas of competition. The banks are presently encountered with omni present factor of various types of financial and non-financial risk in every kind of activity that they undertake. If handled properly, they result as an opportunity for bankers. Risk management has thus become part and parcel of the strategic planning process of bankers. Business grows mainly by taking risk as greater the risk, higher the profit and hence the entity must strike a trade-off between the two. Risk is the potentiality that both the expected and unexpected events may have an adverse impact on the bank's capital and earnings. While the expected losses are generally taken care of by suitable pricing methodology, the unexpected losses, both on account of individual exposure and the whole portfolio in entirety, is to be borne by the bank itself and hence is to be taken care of by the requisite capital. Hence the need for suitable capital structure and sufficient Capital Adequacy requirements is felt (Raghavan, 2004). Capital is essential and critical to the perpetual continuity of a bank as a going concern. A minimum amount of capital is required to ensure safety and soundness of the bank and also to build trust and confidence of the customers. A bank with a sound capital position is able to pursue business opportunities more effectively and has more time and flexibility to deal with problems arising from unexpected losses thus achieving increased profitability (Athanasoglou et al., 2005).A Study by Hassan (2001) examined the performance of Islamic banks' world wide during 1994-2001. Variety of internal and external banking characteristics were used to predict profitability and the result indicated high capital lead to high profitability. Abreu (2002) found that well capitalized banks face lower expected bankruptcy costs and thus lower funding costs and this resulted into better profitability. Stiroh (2002) assessed the potential benefits from the diversification of activities and increasing reliance on non-interest income. The result suggested that non interest income, particularly, trading revenue, is associated with higher risk and lower risk-adjusted profits. The results also showed few obvious diversification benefits from ongoing shift toward non interest income.

Jiang et al., (2003) attempted to quantify factors affecting the profitability of banks in HongKong. The study found that pressures on bank profitability from their more traditional business have intensified, causing them to diversify into non-interest income generating business to remain competitive. The Study also found that equity capital ratio was not significantly related to bank profitability. Goddard (2004) investigated profitability of Euro peon banks using cross sectional data during 1990s. The results showed the relationship between the capital-asset ratio and profitability is positive. Another study, Haron (2004) measured the impact of some of the determinants of profitability. The factors such as liquidity, deposit items, asset structure, inflation and money supply had a significant long term impact on profitability. Athanasoglou (2005) examined the effect of bank specific, industry specific and macroeconomic determinants of bank profitability. The coefficient of capital variable was positive and highly significant, reflecting the sound financial condition of Greek banks. Kosmidou et al., (2005) investigated the impact of banks" characteristics, macroeconomic conditions and financial market structure on banks' net interest margin and return on average assets (ROAA) in the UK commercial banking industry over the period 1995-2002. The results showed that capital strength was one of main determinants of UK banks performance providing support to the argument that well capitalized banks face lower cost of going bankrupt, which reduces their cost of funding or that they have lower needs for external funding which results in higher profitability. …

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