Bank Capital Regulation and Its Impact on Capital and Risk of Commercial Banks in Ethiopia
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Date
2015-06
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Addis Ababa University
Abstract
The effectiveness of risk based bank capital regulation as outlined in the Basel I framework and its national diversities, has been debated. Specifically, the arguments are related to the frameworks objective of linking bank capitalization and levels of risk involved in their asset portfolio. Within this objective of the risk based capital regulation framework, this study attempted to investigate the effectiveness of the national version of the framework followed to regulate banks’ capital in Ethiopia. The study is framed around the competing and yet unsettled theoretical arguments and empirical findings on bank capital and risk relationship and the role bank capital regulation plays. The partial adjustment model introduced in earlier works is applied to explain observed changes in the risk and capital levels. According to this model observed changes in the capital and risk levels are the results of short term adjustments made to achieve equilibrium target levels. Thus, in this adjustment process capital regulation comes with its intuitive influence on the speed and direction of adjustment. Instead of the simple panel OLS or TSLS estimations which are less consistent and inefficient, the model is estimated using the asymptotically more efficient system three stage least square method. The result revealed that adjustment in capital and risk are negatively related for Ethiopian banks. Besides, introducing a regulatory pressure variable defined as the size of the standardized capital buffer banks maintain above the minimum, found to be with significant effect only when consideration is made to the volatility of capital level. When this variable is interacted with the cross coordinating risk and capital variables, the result showed that the coordination between risk and capital adjustment is insignificant for banks with low capital buffer while it is negative for banks with high capital buffer. Besides, banks with low capital buffer prefer to adjust their capital than their risk level while banks with high capital buffer prefer to reduce their risk than increase their capital. The capital buffer size banks hold above the minimum fails to explain the variation in capital and risk adjustment preferences of banks in Ethiopia implying that the influence of the capital regulation framework is limited. Therefore, the regulator need to take measures that link capital requirement with level of risk aversion, direct its supervisory effort on those banks with low capital buffer standard and reconsider its use of enforcement mechanisms.
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Impact on Capital and Risk of Commercial Banks in Ethiopia