IMPACT OF BASEL GUIDELINES ON RISK-TAKING IN INDIAN BANKS: A SIMULATANEOUS EQUATION APPROACH TAMAL DATTA CHAUDHURI* AND ANKIT KUMAR

HISARIA** *Professor, Calcutta Business School, Diamond Harbor Road, P.O. Bishnupur ,(Opp. to Nilgiri Cinema), 24 Parganas (South) - 743 503, West Bengal, India. Ph No: 9831054204, email: tamalc@calcuttabusinessschool.org and tamal5302@yahoo.com

** 2nd year, PGDM student, Calcutta Business School, Diamond Harbor Road, P.O. Bishnupur ,(Opp. to Nilgiri Cinema), 24 Parganas (South) - 743 503, West Bengal, India. Ph No: 9831234178, email: ankithisaria@gmail.com , ankith2012@calcuttabusinessschool.org For any correspondence please refer to tamalc@calcuttabusinessschool.org, tamal5302@yahoo.com or ankithisaria@gmail.com ABSTRACT After the introduction of Basel guidelines I, II & III, Indian Banks have adopted risk based management. This paper focuses on the relationship between the Risk-Taking and Capital in Indian Banks in a simultaneous equation framework. Actual capital adequacy in Indian banks is higher than regulatory capital. This should prompt risk taking. On the other hand, risk taking should generate higher returns improving capital adequacy. The paper considers these effects both for private sector banks and public sector banks for the period 2007 to 2013. The distinguishing feature of this paper is that it enables one to examine how far the two sets of banks have been able to adjust to unexpected risk. The model introduces the concept of coefficient of indexation and we derive values of this from our model.
Keywords: Basel I, II and III, bank regulation, risk taking, bank capital.

1. Literature Review Prudential regulation often imposes regulatory capital requirements in order to create the necessary cushion to protect banks against unexpected losses and ultimately failure (Dewatripont and Tirole, 1994; Goodhart et al., 2003; Pennacchi, 2005; Goodhart, 2008; amongst others). One of the principles in the design of capital requirements is to make them risk sensitive, obliging banks to put aside more capital when they enter into more risky positions. Therefore the efficiency of regulatory capital requirements is intrinsically linked to their capacity to make low capital buffers banks rebuilt their buffers by simultaneously raising capital and lowering risk. However, capital requirements may not contribute to reduce banks risk-taking behavior and can even create perverse effects on bank safety (Koehn and Santomero, 1980; Kim and Santomero, 1988; Clare, 1995; Blum, 1999). Ediz et al. (1998), Aggarwal and Jacques (1998, 2001), Rime (2001) and Van Roy (2008) found that banks reacted to the regulatory pressure by adjusting their capital ratios primarily through capital rather than through risk.

2. Introduction Commercial Banks were exposed to the concepts of income recognition, assets classification, provisioning and capital adequacy and they had to adopt these norms. The health of the Indian banking system underwent a significant change and with greater disclosure, their balance sheets became more transparent and robust. The stock market also recognized this and better multiples were observed. With the opening of the financial sector, new private sector banks entered the banking sector and they adopted these new guidelines from the very beginning.

With the strengthening of the balance sheets of the banks, subsequently. Basel II guidelines have been circulated by Reserve Bank of India and these focus on risk management and the alignment of capital with the extent of risk that a bank can undertake. While Basel I was backward looking in the sense that they provided the banks with indicators about their financial health, Basel II was forward looking and provided a framework for efficient operations, keeping in view the risk-return trade-off. Although the importance of regulatory capital was maintained, the concept of economic capital was also floated equally important. Banks became aware of the importance of the concept of capital adequacy, beyond it being only a regulatory requirement. Estimating the probability of default, market risk, operational risk and risk based pricing have now entered the realm of Indian Banking. There is a pressure on Indian banks for upgrading both technology and human resources to meet these requirement. Although it is around 2002 that RBI introduced the Basel II guidelines, there is a significant differences among Indian banks today in their level of preparedness for adopting these norms. There is a general impression that new private banks are more ready than nationalized banks. Among nationalized banks, State Bank of India and Bank of Baroda may be more ready than their counterparts. Leaving aside inter-group differences, if we classify Indian banks broadly into private sectors banks and nationalized banks, then it would be interesting to analyze the level of preparedness of these two sets of banks in terms of risk taking and alignment of capital with risk. The purpose of this paper is to empirically investigate the relationships between risk undertaken by the above two sets of banks in relation to their capital in terms of a simultaneous equations model. The paper will follow the methodology developed in Shrieves and Dahl (1992) and on its extensions by Jacques and Nigro, 1997; Aggarwal and Jacques, 1998-2001; Rime, 2001; Hassan And Hussain, 2004; Heid et a 2004; Murinde and yassen, 2004; Godlewski, 2004;

and Bouri & Ben Hmida (2006). As in the literature mentioned above, the variables that will be considered are actual capital, desired capital, actual risk and desired risk. However, our model will build in a simultaneity that is absent in the adjustment mechanism postulated in the papers. As mentioned above Indian banks have been exposed to the Basel norms for quite some time. With the opening up of the financial sectors, many of them accessed the market for equity capital more than once to shore up their Tier I capital to boost capital adequacy. The purpose of this paper is to show whether Indian banks have been judicious in their risk taking and whether their risk taking has been in lines with the capital requirements. Before we proceed with the model ----- it is important to understand the implication of Capital Adequacy Ratio (CAR) as a single parameter to monitoring banks by the regulators. It is defined as a ratio with some definition of capital in the numerator and total risk weighted assets (RWA) in the denominator. Indeed fixation of minimum value of CAR enables the regulator to fix the extent to which the bank can have risk weighted assets. As of today, CAR is 9% in India which implies that banks can have around eleven times its capital as RWA. As banks are naturally positioned for resources, deposits keep flowing into a bank. These have to be converted to assets, with the overall restriction of 9%. The better the quality of assets, lower is RWA even with a large actual assets base. The quest for banks is thus for quality assets to lower RWA. On the other hand, greater the credit rating of an exposure, lower is the yield and thus profitability. To look at higher returns, banks have to turn to riskier assets, which would increase the denominator. Thus the other thrust area for the banks is to increase the numerator. If banks cannot access the market for equity for various reasons, they raise Tier II bonds to shore up their capital base and protect their capital adequacy The purpose of this paper is three-fold. The first is to develop a simultaneous equation model where the two variables. CAR and risk, are interdependent. It is postulated that whereas greater risk taking ability is determined by CAR, greater risk necessitates a larger capital base

and hence CAR. The second purpose is to examine, in terms of the above framework, how the two sets of banks, private sector banks and nationalized banks, have arrived at their actual CAR and overall actual risk profile and the extent of sensitivity of the above two variables respect to the explanatory variables. The third purpose and the most important one is to examine how far the two sets of banks have been able to adjust to unexpected risk. Accordingly, Section II describes the model and the empirical results are presented in Section III. Section IV concludes the paper. 3. The Model. The structural form of equations that we consider are given by RISKt (1) CARactt = CARt-1act + n (RISKt RISkt-1) + (1-n) (RISK et RISkt-1) + k CRRISKt-1 = CARt-1act + (RISKt RISkt-1) + (n) (RISKt RISk (2) RISKet 2= RISKt-1 + b (RISKt-1 RISKt-2) + cVULNERt-1 + dCLSTATEt-1 + eSIZEt-1 (3) Where RISK CARact CARreg CRISSK SIZE - Risk Weighted Assets/Total Assets - Actual Capital Adequacy Ratio - Regulatory Capital Adequacy Ratio - Credit Risk defined as Provision Total Advances - Level of Bank Deposits
e t-1)

RISKt-1

(CARactt

CARregt)

+ k CRRISKt-1

VULNER CLSTATE Subscript t Superscript e

- Ratio of Deposits to Risk Weighted Assets - Ratio of Government Security Holdings to Total Assets - Time - Expected Value

The variables that are considered in this paper are: RISK- Risk Weighted Assets/ Total Assets CARact- Capital Adequacy Ratio (Actual) CRRISK- Credit Risk defined as Provisions/Total Advances VULNER- Ratio of Deposits to Risk-Weighted Assets CLSTATE- Ratio of Government Security Holdings to Total Assets SIZE- level of bank deposits

The choice of the variables is based on Bouri & Ben Hmida and related literature. As there are different risk weighted attached to assets with different credits ratings, a comparatively higher value of risk indicates that the bank has gone in for riskier assets with low credit rating for higher return. CAR is the actual capital adequacy of the bank as reflected in its balance sheet. This variables reflects capital as defined by the regulator in the numerator and risk-weighted assets in denominator. A specific regulatory value of this (9% in India) limits the extent of risky asset Acquisition vis--vis capital; defines the risk capital relationship. CRRISK is another way of looking at risk. It shows the extent of provisions that have been made by the bank against its total advances portfolio. Worse the quality of advances, the riskier they are, and hence the requirement of higher provisions.

It is commonly observed that greater the deposit of the bank in relation to its risk weighted asset base, greater is its vulnerability in the event of deposits withdrawal. The ratio VULNER indicates this liquidity risk that banks face. It creates risky assets, which becomes sticky and illiquid; the bank will face difficulty in meeting depositors cash withdrawal requirement. On the other hand, CLSTATE indicates the extent of risk aversion of the bank. The ratio has Government Securities in the numerator and although such instruments have low yield, their credit quality is high. Banks that have a high value of CLSTATE can be said to have less risky portfolio. Regulatory capital is expressed through the required. Capital adequacy ratio as fixed by the central bank. It is different from economic capital. Which explains the amount of capital required to absorb a default. Although the ultimate purpose of regulatory capital is absorption of loss in the event of default, it primarily restricts overexpansion of risk weighted assets in relation to the capital of the banks. If actual capital adequacy ratio exceeds the regulatory capital adequacy ratio, then there is a buffer which leads banks to take more risks which gets reflected in the ratio of risk weighted assets to total assets. This follows from the usual risk return trade-off. If there is flexibility in the banks to take risk, they would take risk, and this is the basis of Equation 1. It also reflects the dynamic nature of portfolio allocation and its relation to capital allocation. Equation 2 gives an indexation specification of the actual capital adequacy ratio. The equation indicates that actual capital adequacy is fully indexed to expected risk and partly indexed to unexpected risk, implying between zero and one. Estimation of the indexation coefficient is of interest by itself, as it would show to what extent Indian banks have been able to estimate unexpected risk and adjust capital accordingly. The results would be even more interesting as we would be estimating this parameter for both private sector banks and private

sector banks separately. The equation also includes CRRISK, which denotes the cover for risk that is already there in portfolio. Equation 3 specifies that the expected level of risk that a bank can take is determined by past risk taking by the bank given by a lag structure and also by VULNER and CLSTATE. Greater the value of VULNER, lower would be the expected risk taking by bank as, with a similar distribution of returns, the impact of probability of default increases. With respect to CLSTATE, the expected sign is negative as greater proportion of funds in Government Securities implies greater liquidity and lower risk. Larger the SIZE, greater is the expected risk taking as the bank is confident of raising capital any time it needs. It has a relation with goodwill and market perception. Equation 1, 2 and 3 give a simultaneous equation structure to capital adequacy and risk taking by a bank. There are three equation in three unknowns RISKt, CARtact and RISKte. The other variables are treated as exogenous for the model. From here we drive two reduced form equation in RISKt and CARtact and estimation results are given in TABLE 1 to 4 Section 3. The variables that we choose in the paper are those that have been used by Bouri & Ben Hmida (2006). However, our model is different from their structural form given by the two equation. CARt = CARt-1 + a (CARte CARt-1) RISKt = RISKt-1 + b(RISKte RISKt-1) Where the other variables mentioned in this paper enter through the starred variables, the expected values. Our emphasis is on the specification of the simultaneous equation structure, which the literature has not specified. 4. Data

The three equation of our model bring out the interdependence between risk and capital, which is the basis of risk management. The data for the study has been taken for the period 2007 to 2013 on fifteen nationalized and fourteen private sector banks. From the structural equation in Section 2, we derived two reduced form equation in CARt and RISKt. We then ran a regression on the pooled cross section time series data and the estimation results are given in Tables 1 to 4.

5. The Results The estimation results for the public sector banks are given in table 1 & 2 Table 1 Public Sector Banks, Dependent Variable: CARt Variables Coefficients t-value Rsquare CAR t-1 RISk t-1 RISK t-2 CRRISK t-1 VULNER t-1 CLSTATE t-1 SIZE t-1 0.376 0.035 0.007 -1.026 0.006 -0.057 -1.46E-08 4.113 0.965 0.584 -2.867 0.478 -1.488 -2.204 0.301

Table 2

Public Sector Banks, Dependent Variable: RISKt Variables CAR t-1 RISk t-1 RISK t-2 CRRISK t-1 VULNER t-1 CLSTATE t-1 SIZE t-1 Coefficients 1.432 -0.040 0.024 -2.184 -0.172 -0.244 7.38E-08 t-value 1.849 -0.133 0.252 -0.722 -1.693 -0.755 1.319 R-square 0.439

The estimation results for the Private Sector banks are given in table 3 & 4

Table 3 Private Sector Banks, Dependent Variable: CARt Variables CAR t-1 RISk t-1 RISK t-2 CRRISK t-1 VULNER t-1 CLSTATE t-1 SIZE t-1 Coefficients 0.482 0.143 0.009 0.039 0.033 -0.001 -2.62E-08 t-value 4.497 2.522 0.374 0.091 1.539 -0.010 -0.862 R-square 0.386

Table 4 Private Sector Banks, Dependent Variable: RISKt Variables CAR t-1 RISk t-1 RISK t-2 CRRISK t-1 VULNER t-1 CLSTATE t-1 SIZE t-1 Coefficients -0.018 0.284 -0.011 3.129 -0.125 -0.591 2.713E-07 t-value -0.036 1.060 -0.097 1.558 -1.225 -1.550 1.882 R-square 0.622

6. Conclusion

7. References

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