ISSN (Print) - 0012-9976 | ISSN (Online) - 2349-8846

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Do Private Sector Banks Manage Equity Capital Competently Compared to Public Sector Banks?

Evidence from India

Private sector banks hold equity capital in excess of the regulatory requirement (400 basis points more from 2006 to 2017). The impact of excess capital in banks is examined through a partial adjustment approach with unbalanced panel data for listed Indian banks from 2006 to 2017. Findings reveal that banks hold excess capital ratios, and private sector banks actively manage higher capital ratios than the public sector banks. The speed of adjustment for private banks is much higher than for public sector ones, and an inverse relationship between non-performing assets and change in equity capital is found.

As one of the most regulated industries, banks have to abide by several regulatory requirements such as limiting their leverage within the prescribed limit. Conversely, the management of banks is concerned about excessive equity capital since it is more expensive than debt finance.1 The Reserve Bank of India (RBI) provides guidelines to uphold the capital ratio for banks operating under the jurisdiction of India.2 After the implementation of Basel III, banks have to maintain tier 1 capital of 7.625% and a capital adequacy ratio (CAR) of 9.625%.3,4 According to the Basel Committee on Banking Supervision (the committee, hereafter), the leverage requirement of each bank is 4% of the total assets.5 It is observed that the present supervisory procedures permit some discretionary benefits to “well-capitalised” banks that hold tier 1 capital of at least 8% of risk-weighted assets (RWA) and total regulatory capital above 11% of RWA.6

Banks hold more capital than required due to various motives. It avoids raising new equity with high transaction costs (Beger et al 2008). Myers (1977) asserts that adding new equity may transfer value to fixed income claimants, as in a “debt-overhang” situation. However, when the transaction cost reduces, then firms raise the funds through external equity finance (Huang and Ritter 2009). Maintaining excess capital (capital cushions) has implications for the efficacy of bank capital regulations. The major motivation for capital cushions is to mitigate the risk of insolvency during recession, restricting credit extension and possibly exacerbate the situation. However, if banks reduce their capital ratio during recessionary periods, then it can increase the probability of bank default and also reduce liquidity creation in the process (Demsetz et al 1996; Buch and Prieto 2014; Hellwig 2010).

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Updated On : 15th May, 2022
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