Regulatory capital and risk of Indian banks: a simultaneous equation approach

What is it about?

This paper tries to examine the association between regulatory capital and risk of Indian commercial banks and examine the impacts of other relevant variables on them. The study is based on a secondary data set on Indian commercial banks collected from ‘Capitaline Plus’ corporate database and annual reports of the respective banks. Total 41 major Indian banks (21 public and 20 private sector banks) are considered in this study. Here absolute values of capital and risk are used as dependent variables along with some relevant bank specific explanatory variables in a system of two equation model. Based on the nature of interrelationship and identifiability of the equations, 3SLS technique is used to estimate the relationship. Risk and capital of Indian commercial banks are inversely associated. The influence of profitability on both capital and risk is significantly positive. Moreover, Human capital efficiency is negatively associated with the undertaking of risk by the banks. In this respect, Indian private sector banks are found to be more efficient in utilizing human capital for reducing credit risk.

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Why is it important?

Management of risk has emerged as one of the core banking activities all over the world since the banking crisis observed in different countries. The preservation of risk-based capital as per the guidelines of Basel Committee on Banking Supervision is considered as an important yardstick for measuring the solvency or financial stability of banks. But the determination of the adequate percentage of risk-based capital ratio is still in the evolving stage. In this situation, the most important is to access how effectively a bank could utilize its regulatory capital to minimize the risk or in other words, improve its financial soundness. The findings of the present study in the context of Indian banking sector would help policy or decision makers in different ways. First, the observed negative association between bank regulatory capital and risk indicates that a bank can reduce its risk by enhancing its capital base. Alternatively, if a bank can efficiently manage its credit activities by reducing NPAs, minimum capital base may provide sound financial health. This is evident in Indian banking sector during 2002-2008. Secondly, the role of human resource is very vital in the overall functioning of a financial institution in general and in the management of credit risk in particular. In this respect mention can be made about the study of National Skill Development Corporation in India. The study clearly points out the importance of the skilled human resources and other components of intellectual capital as key success factors for banking and financial service sectors. The observed negative association between human capital efficiency and bank risk in the present context is an added contribution of the paper that may be a valuable tool for decision makers. Finally, profitability also influences the bank risk and capital positively, which is on the expected line. Higher profit potential entices the banks to take more risk and at the same time more profit adds to the stock of existing capital.