Regulatory capital requirements: can the banks mitigate the risk through lending rates?

Abstract

PurposeThe purpose of this study is to investigate the impact of the new capital requirements under the Basel III framework on bank lending rates.Design/methodology/approachBy constructing a stylized representative bank's financial statements, the authors show that the higher cost associated with a 1-percentage increase in the capital ratio can be recovered by increasing the bank lending rate.FindingsThe results indicate that in the case of scheduled commercial banks, a 1-percentage-point increase in the capital ratio can be recovered by a commensurate increase in the bank lending rate by 16 basis points and would go up to an extent of 94 basis points for a 6-percentage point increase assuming that the risk-weighted assets are unchanged.Practical implicationsThe results assume significance as the estimations for the scenarios of changes in risk-weighted assets change in return on equity and the cost of debt. Given the enormous significance of the impact of Basel III on banks, this research outcome benefits the practitioners in the industry and researchers.Originality/valueThis study contributes to the literature on bank regulation and risk management with a newer and topical approach for quantification of the impacts of new regulatory standards. Another contribution of this study is that it considers three different groupings of banks: (1) scheduled commercial banks; (2) public sector banks and (3) private banks in Indian banking. This is the first of its kind in the context of studying Indian banking.