Cyclical Implications Of The Basel Capital Standards: An Investigation From Pakistan
Author: Romila Qamar

New risk based capital requirement have pro-cyclical effect and causes negative externalities. During recession, on one side, quality of loan portfolio deteriorates and probability of default increases resulting into increased provisions and writes off’s and reduced capital level. This causes an increase in capital requirements which becomes more expensive. Weaker banks fail to access new capital and ultimately reduce the credit supply. On the other side, banks are required to maintain the minimum capital which results into credit supply contraction and hits the bank’s profitability leading to a situation called Credit Crunch. This situation may prolong recession. During the crisis, developing countries are more affected than developed countries. But, this debate is entirely new in Pakistan. This research empirically investigates the pro-cyclical effect of new capital regulation under Basel II using panel data of 47 Pakistani Banks over the period of 12 years from 2001-2012. Particularly this study examines the capital management mechanisms via loan loss provisions and capital buffers along with other managerial objectives, using Generalized Method of Moments (GMM) one step and two step estimation techniques on dynamic panel data models of provisioning and bank profit. This is the only study which has utilized two models to investigate the cyclical implication of new Capital Accord and provided comparative analysis of the results. The study firstly investigates the cyclical impact before and after adding foreign and Islamic banks. Then, to examine this issue in pre-Basel regime and post-Basel regime, the study divides the sample into two periods. To explore, which type of banks are more affected by new capital regulation according to their ownership, banks are divided into five categories, public, private, foreign, Islamic and specialized. Lastly, to compare the cyclical impact according to bank size, the banks having assets more than 100 billion are taken as large banks and rest are considered as small banks. The results before and after including the foreign and Islamic banks are same and gives the evidence that new capital regulation is pro-cyclical. Same results are found for post-Basel regime but these are reversed in pre-Basel regime for Tier1 and Tier2. Pakistani banks use LLP for capital management and not for income smoothing except foreign banks which use LLP for earnings management. No significant difference found for large and small banks. Negative relation of LLP with business cycle fluctuations confirms that new capital regulation is pro-cyclical and Pakistani banks use backward looking provisioning policies. The results of capital buffer model gives the evidence that capital buffer are counter-cyclical except in case of specialized banks because difference that they have in their operations as compared to others. The findings also suggest that cost of adjustment, cost of raising capital and bankruptcy costs are major determines of holding capital buffer. There is no significant difference found for two regimes under discussion. Analysis of capital buffer equation for large and small banks, confirms too big to fail hypothesis. Form the results it is concluded that new Basel capital regulation is pro-cyclical and capital buffer are counter cyclical consistent with hypothesis. The research enrich the literature regarding pro-cyclical capital regulation, capital management, earnings management and signaling via loan loss provisions, counter cyclical capital buffers, determinants of capital buffer from a developing country, Pakistan and it has important policy implications. The findings suggest the banks to adopt forward looking provisioning policies. Supervisor:- Dr. Shahid Mansoor Hashmi

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Keywords : Basel Ii, Capital Buffer, Capital Regulation, Income Smoothing, Loan Loss Provisions, Pro-cyclicality, Signaling, Tier 1 Capital, Tier 2 Capital
Supervisor: Shahid Mansoor Hashmi

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