Kathmandu, March 25

Higher capital requirement at banking institutions exerts pressure on promoters to closely monitor banking activities, which compels the management to maintain a discipline and, thus, reduces the cases of loan defaults, says a latest study conducted by Nepal Rastra Bank (NRB).

The working paper titled ‘Theoretical Paradigm on Bank Capital Regulation and its Impact on Bank-Borrower Behaviour’ analyses how higher capital requirement at banking institutions affects the behaviour of bankers and borrowers, and contributes to financial stability.

The paper, prepared by NRB Director Gunakar Bhatta, however, looks into a single measure of raising capital, namely fresh capital injection by investors, overlooking other means, such as mergers and acquisitions, through which core capital of banks and financial institutions could be raised.

“Raising capital is a costly affair. It requires long-term commitment from investors. Also, these investors are the ones who are paid the last, if the financial institution goes bankrupt and initiates liquidation process,” says the paper. “These reasons prompt capital owners to take extra precaution and exert pressure on bank management to increase monitoring once fresh capital has been injected. Thus, higher equity requirement should lower the loan-loss frequency at banks and contribute to preserving the financial stability.”

Global financial crisis of 2008 has reinforced the fact that financial intermediation lies at centre of economic activities. To ensure smooth financial intermediation, sound health of financial intermediaries is necessary. A banking institution can maintain sound financial health only if it has adequate level of capital.

In other words, capital works as a cushion and averts possible insolvency of a bank as long as losses emanating from loans and other investments do not exceed the capital.

This means ‘banks and financial institutions that do not have adequate stock of capital have higher chances of failing, especially during economic downturns’.

This is because capital-stressed banks are unlikely to extend credit at times of business cycle downturn, says the paper. “If a bank does not meet financing requirement of an ongoing project, the project may discontinue operation, raising risk of loan default,” adds the paper. “Continuation of this cycle might invite systemic risk, which ultimately challenges stability of system as a whole.”

The paper broadly assumes that borrowers may default on their promise of servicing debt any time, because in a real world, ‘information is imperfect (or not everyone knows what a given individual knows), behaviour is opportunistic (or people cannot credibly commit their future actions) and perfect competition is at best an approximation’.

Since borrowers’ behaviour is prone to moral hazard, proper monitoring of banking institutions is necessary, says the paper. “Thus, a higher equity requirement exerts monitoring pressure on investors. In the end, this mechanism helps maintain discipline in the financial system.”

Moreover, the prudential capital requirement by the regulatory agency compels banks to maintain a desired level of capital adequacy, which plays a catalytic role in the allocation of bank resources, adds the paper, which has simply provided a theoretical basis in modelling behaviour of banks and borrowers in the event of higher equity requirement. “Also, prudential capital requirement preserves the interest of small depositors who cannot monitor the behaviour of banks directly.”