Modeling effects of banking regulations and supervisory practices on capital adequacy state transition in developing countries
| DOI | https://doi.org/10.1108/JFRC-08-2018-0113 |
| Pages | 130-159 |
| Published date | 19 September 2019 |
| Date | 19 September 2019 |
| Author | Ali Jamali |
Modeling effects of banking
regulations and supervisory
practices on capital adequacy state
transition in developing countries
Ali Jamali
School of Management, University of Tehran, Tehran, Iran
Abstract
Purpose –The FDIC Improvement Act of 1991 setsout five categories of capital and mandates corrective
action for banks.Each bank based on its capital amount fall in the certain categories or states. The purposeof
this paperis to consider the effect of banking regulations and supervisorypractices on capital state transition.
Design/methodology/approach –First, the authors investigate how much the practices influence
banks’capital adequacy usinga dynamic panel data method, the generalized method of moments.Then, to
scrutinize the results of the first phase,the authors estimate the effect of practices on some characteristicsof
capital state transition suchas transition intensity,transition probability and state sojourn time using multi-
state modelsfor panel data in 107 developing countriesover the period 2000 to 2012.
Findings –The dynamic regression results show that capital guidelines, supervisory power and
supervisory structure can have significantly positive effects on the capital adequacy state. Moreover, the
multi-state Markov panel data model estimationresults show that the significantly positive-effect practices
can change the capital state transition intensity considerably; for example, they can transmit the critical-
under-capitalized(the lowest) capital state of banks directly to a well or the adequate-capitalized(the highest)
capital state without passing through middle states (under-capitalized and significantly-undercapitalized).
Moreover,the results present some new evidence on transition probability and statesojourn time.
Originality/value –The main contribution of this paper, unlikethe existing literature, is to consider the
power of banking regulations and supervisory practices to improve the capital state using a multi-state
Markov paneldata model.
Keywords Generalized method of moments, Banking regulations and supervisory practices,
Capital adequacy, Multi-state Markov panel data model
Paper type Research paper
1. Introduction
Banks are fragile institutions that need government help to evolve in a safe and sound
environment by setting appropriate regulations and supervisory practices. Hence, the
purpose of regulationsand supervisory practices is to contribute to achieve well-functioning
banking systems. Main regulationsand supervisory practices according to Barth et al. (2001,
2004,2013) are as follows: entry into commercial banking, capital standards, allowable
activities for banks, deposit protection schemes, supervisory powers associated for dealing
with banks in financial duress and the mandate, staffing and structure of supervisory
agencies (Barth et al.,2013,2004,2001). The wave of bank and loan failures in the 1980s and
early 1990s as well as the resulting losses to deposit insurance fundsserved to highlight the
need for banks to hold sufficientcapital to survive difficult times. Consequently, recentbank
regulatory initiatives increasingly have emphasized the role of bank capital as a cushion to
allow banks to absorb adverse shocks without experiencing insolvency. Recent bank
JFRC
28,1
130
Received20 August 2018
Revised26 April 2019
Accepted22 July 2019
Journalof Financial Regulation
andCompliance
Vol.28 No. 1, 2020
pp. 130-159
© Emerald Publishing Limited
1358-1988
DOI 10.1108/JFRC-08-2018-0113
The current issue and full text archive of this journal is available on Emerald Insight at:
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legislation and regulations have sought to implement a carrot-and-stick approach that
penalizes banks with insufficient capital while reducing the regulation imposed on banks
deemed to be well capitalized (Peek and Rosengren, 1997). Tighter supervision and new
regulations typically aim to address the deficiencies of loose or outdated regulations.
However, regulatoryreform may also hold the risk of over-regulation, particularly whenit is
undertaken under the impression of a severe crisis. Over-regulation might have negative
welfare-effects (James, 2015). Barth et al. (2006) argue that the “public view”of bank
regulation aims to maximize benefits to the general public and minimize financial losses
which might impact the public at large. However, with the “private”view, it is suggested
that regulation is set up to benefit particular interest groups such as banks themselves or
politically well-connected organizations such as government-owned banks (Barth et al.,
2006). The existing literature is full of various researches, each of which, in the context of
these two perspectives, examines the effects of regulations and supervisory practices on
various functional dimensions of banking system performance including capital state (see
for instance Agoraki et al.,2011;Banker et al.,2010;Barth et al., 2004,2001,2013;Becket al.,
2006;Deli and Iftekhar, 2016;Delis et al., 2011;Gordon et al., 2014;Kupiec et al.,2016;Triki
et al.,2017;Teixeira et al., 2014). Regulationsand supervisory practices seek to manage bank
risks mainly by monitoring the amount of capital a bank or financial institution has to hold
as required by its financial regulator.Therefore, examination of these regulations influences
on the capital state of the banks is important and many works have attempted to do so
(Hakenes and Schnabel, 2011;Teixeira et al., 2014;Bougatef and Mgadmi, 2016). A more
important issue, however, is to what extent the influential regulations and supervisory
practices have been able to improve a bank’s capital adequacy level. In other words, it is
important to know whether the effectual regulations really satisfy the objectives of
policymakers in nationaland international regulatory associations.
The Prompt CorrectiveAction (PCA) is a global benchmark to categorize different capital
adequacy states. It is a US federal law mandating progressive penalty against banks that
exhibit progressively deteriorating capital ratios aiming at achieving the “well-capitalized
banking system”objective. The FDIC PCA sets out five states of capital including well-
capitalized if the bank has a total risk-based capital ratio of 10.0 per cent or greater,
adequately-capitalizedif the bank has a total risk-based capital ratio of 8.0 per cent or greater,
under-capitalized if the bank has a total risk-based capital ratio of less than 8.0 per cent,
significantly-under-capitalized if the bank has a total risk-based capital ratio of less than 6.0
per cent, and critically-under-capitalized if the bank has a total risk-basedcapital ratio of less
than 4.0 per cent (FDIC, 2000). The main contribution of this paper, unlike the existing
literature, is to answer the question, “How have regulations and supervisory practices been
able to change the capital state defined by the FDIC in banking sectors of developing
countries?”In fact, while the presentstudy is related to examining the impact of regulations
and supervisory practices on bank capital state such as Teixeira et al. (2014) or Gropp and
Florian (2010), it is fundamentally different from the current literature because of the
following contributionsit will make:
determining the capital state transition intensity matrix with regard to the role of the
regulations and supervisory practices variables;
determining the capital state transition probability matrix with regard to the role of
the regulations and supervisory practices variables;
determining the capital state mean sojourn time with regard to the role of the
regulations and supervisory practices variables; and
determining the frequency distribution table of capital state transition.
Modeling
effects of
banking
regulations
131
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