Basel III capital regulations and bank profitability

• Author: Vighneswara Swamy
• Date: 01 October 2018
• Published date: 01 October 2018
• DOI: http://doi.org/10.1002/rfe.1023

ORIGINAL ARTICLE

Basel III capital regulations and bank profitability

Vighneswara Swamy

Economics and Finance, IBS-Hyderabad,

IFHE University, Hyderabad, India

Correspondence

Vighneswara Swamy, Economics and

Finance, IBS-Hyderabad, IFHE University,

Hyderabad, India.

Email: vswamypm@gmail.com

Funding information

Indian Institute of Banking and Finance

(IIBF)

Abstract

This study models the impact of new capital regulations proposed under Basel III

framework on bank profitability in India by constructing a stylized representative

bank’s financial statement. It shows that, with an increase in the capital ratio in

the context of new capital regulations, the banks tend to experience a rise in inter-

est income. The results indicate that in the case of scheduled commercial banks,

assuming that RWAs are unchanged, for 1-percentage point increase in capital

ratio, interest income would rise by 17 percentage points and would go up to an

extent of 62 percentage points for six-percentage-point increase assuming that the

risk-weighted assets are unchanged. It also provides the estimations for different

groups of banks and the scenarios of changes in the risk-weighted assets, and

changes in the capital ratios.

JEL CLASSIFICATION

G2, G21, G28, E44, E51, E61

KEYWORDS

banks, basel III, capital, interest income, regulation

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INTRODUCTION

A growing strand of bank capital regulation literature in favor of the Basel III framework for b ank capital regulations,

argues that there are significant macroeconomic benefits of raising bank equity. However, there have been debates about

the desirability and the impact of new capital regulations on the profitability of banks. Higher capital requirements lower

leverage and the risk of bank bankruptcies (Admati, DeMarzo, Hellwig, & Pfleiderer, 2010). On the other hand, there is

another strand of literature, which argues that there could be significant costs of implementing a regime with higher capital

requirements (Angelini et al., 2011, and Bank of International Settlements, 2010). The impact of Basel III regulations on

the banks is extensive and affects the bank’s day-to-day decision-making in lending, funding, treasury, capital, liquidity,

and operations. All these areas are closely interconnected, and directly affect the bank’s profitability.

Though literature is rich with studies on bank regulation and its impact (Cohen & Scatigna, 2016; Dermine, 2015; Diet-

rich, Hess, & Wanzenried, 2014; Lee & Hsieh, 2013; Pessarossi & Weill, 2015), very few studies are reported on the mod-

eling of the impact of capital and liquidity requirements on bank profitability except the one by Mich ael (2010). There is a

need to conduct country-specific studies for estimate the impact of new capital regulations under Basel III proposals on the

profitability of banks. This would provide the much-needed logic and rational approac h toward ascertaining these impacts

to policymakers as well as build a body of literature capturing the uniqueness of country specific features (particul arly of

emerging market economies such as that of India) in this direction.

The author expresses his gratefulness to Michael R. King, Bank for International Settlements, Basel, Switzerland, Prof. Tarun Mukherjee, University of

New Orleans and Prof. Shantaram Hegde, University of Connecticut for their valuable views and comments.

Received: 21 December 2017

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Revised: 26 January 2018

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Accepted: 20 February 2018

DOI: 10.1002/rfe.1023

Rev Financ Econ. 2018;36:307–320. wileyonlinelibrary.com/journal/rfe ©2018 The University of New Orleans

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