Case Study: Capital Requirement and Risk Behavior

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[. . .] The repercussion of bank failure has captured the attention of many industry participants. When relating to experiences such as the 1930's great depression, the recent credit crunch and the subsequent financial crisis in the period of 2007-2010, it is evident as to what are the dangers of a bank default to the global banking system. The similarity in all of the three mentioned financial crisis was the causes and the side effects, apparently poor banking regulations and laxity in the regulations which were in place contributed to the financial mess, as for the consequences they were all similar as many banks and mostly the smaller banks had to close shop, while others were offered stimulus package to prevent them from collapsing.

Such scenarios that not only affected the banking system of one country but the entire world wide banking system necessitated the call for a standard global banking regulations. The Bank for international settlement (BIS) was formed as an answer to these calls. The bank for international settlement established a committee known as the Basel Committee which in its' mandate proposed an accord on bank capital minimum levels which was known as the Basel I accord. The Basel I accord aimed at encouraging and attaining an internationally accepted standard minimum capital requirements. By using the Cooke Ratio, it aimed formulating a regulatory requirement based on banks' capital. To attain its objective the Basel I accord raised the capital ratios and encouraged banks to approach credit risk from a different perspective, in that the banks' portfolio risk should be subjective to the bank's capital requirements.

Credit risk is the primary focus of the Basel I accord and it defines it as the risk of loss that is brought about by default of counterparty or a borrower. The accord requires that banks should always meet the established two ratios for capital adequacy that are total capital ratios and tier 1 ratio. Both of the two ratios have similar denominators, which is the risk-weighted sum of the bank on and off balance sheet activities. The numerator for Tier 1 ratio is the bank's core capital that is disclosed reserve plus the shareholders equity capital. As for the total capital ratio the numerator is both Tier 1 and Tier 2 of which Tier 2 capital includes subordinated debt and undisclosed reserves.

The Basel I accord recommends that banks should have at least a capital ratio of 8% which has however being reviewed and a credit risk of 4%. It is important to note that in the capital ratio requirement Tier 2 (also called supplementary capital) contribution should not exceed 50% from Tier 1 (also called core capital). Bankers and economist are of the opinion that banks which wish to meet these Basel I accord requirement should adjust their balance sheet in such a manner so as to raise the capital level, reduce the risk weighted bank assets in proportion to the bank's total assets or reduce its' total assets entirely.

Boot and Thakor (1993, 420-437) and De Carmoy (1990, 45) have faulted the capital regulatory standards such as the international Basel I accord on its aforesaid impact on the banks portfolio risk. The authors suggest that by using a mean-variance framework, it is apparent that an increase in capital requirement standards may have an opposite impact than the one intended as bankers are likely to increase their bank's portfolio risk. When using the dynamic framework Calem and Rob (1996, 36) also concluded that by pressuring under capitalized banks to meet the set capital requirements, it has the likely impact of forcing them to increase their bank's portfolio risk in one period so as to meet the requirements in the subsequent period that follows.

On another study conducted by Enoch, Stella and Khamis (1997, 97-138) which considered the incentives of the manager, shareholder and the deposit insurer in relation to a banks' capital level and the risk taking behavior. Enoch, Stella and Khamis concluded that three mentioned participants have big influence in terms of the level of risk in relations to the capitalization level.

1.7 Egypt's banking sector

According to the World Bank economic guidelines; a country's economic success can be propelled only by a banking system that is well established, profitable and trustworthy. Thou Egypt have experienced a commendable economic growth for the past few years, reports indicate its banking system can't take any credit for it because it is marred with problems associated with non-performing loans, weak supervision and dominant, non-competitive, unprofitable and inefficient public banks. However it is important to note that there is no empirical evidence to substantiate these problems as claimed by the report. But problems such as the non-profitability of public banks mainly attributed to high number of loan loss provisions and low income can be substantiated. Another problem that can be substantiated is related to Egypt's bank structure of the balance sheet which indicates that risk avoidance to be the main approach in credit risk management.

Bhattacharya, Boot and Thakor (1998, 745-770) in their studies lamented that the Egyptian banking industry took a longer than usual time to develop a remark justified by the survey which was conducted by the Business Monitor International group in 2006 which showed at that time only 10% of the entire Egypt's population had owned or owned bank account. This figure is contrary lower to what other countries had even the emerging economies. The public banking institutions that have ever since dominated Egypt's banking sector is another problem that has impaired the growth of the country's banking industry and the economy as a whole.

Since such banks strongly rely on the guaranteed government income and their investment in government's treasury bills and bonds which have a short maturity period coupled with a guaranteed income plus low returns, they had being reluctant to serve the small and medium customers, whom are in dire need of banking services plus they have the potential to develop the economy as much as large clientele can. Furthermore the other factor that contributes to Egypt's poor development in the banking industry is the rate of non-performing loans which is stimulated by poor legal framework that causes collaterals taken on loan to be uncertain guarantee.

Calomiris and Powell (2000, 77-98) noted in their studies that the weak supervision of Egypt's banking sector by the country's central bank is largely to blame for the high number of non-performing loan that has been recorded in the country history, for example according to reports released by the Economist Intelligent unit and the Business Monitor International group in 2006 all showed that total number of bank's bad debts were estimated to constitute at least 20% of the total loan portfolio by 2006. Corruption in the bank lending process that has being facilitated by weak supervision by the central bank has also lead to the high number of non-performing loans. Without regard to future cash flow of the customer, banks blatantly overvalue the assets they bring in as collateral and give such customers loans that end up becoming non-performing loans. On the other hand state owned banks lend public sector companies as a direct order from the government without following the due process of lending; such a case was in 2004 when reportedly four public banks were owed more than thirty billion won by state-owned companies.

Referring to studies conducted by Dobronogov and Iqbal (2005, 42), they attributes the banking reforms in Egypt which were initiated in 2004 to the appointment of a new central bank governor in 2003 and the subsequent appointment of a new cabinet and a prime minister in 2004. For the first time in 2004, the government started taking drastic measures towards both private and public banks which were faced with increasing rate of non-performing loans. Later on other reforms were taken that include acts such as privatization of public banks, restructuring of the entire banking system, revaluation of the capital requirements and the strengthening of banking supervision.

Hellmann, Murdock and Stiglitz (2000,147-165) elaborate on this reform by saying that "the first reform was to raise the capital requirement for banks operating in Egypt" in doing this the central bank of Egypt together with the government formulated a new banking law that is known as 'law no.88/2003' which was effected in July of 2003. Law No. 88/2003 stipulated that the new minimum capital requirement for local banks will be EGP 500 million while that for foreign banks with branches in Egypt will be 50 million U.S. dollars. Moreover the law also required that bank abide by the set 10% risk-weighted capital adequacy ratio. These strict conditions set by the law resulted to mergers and acquisitions between banks as they tried to beat the deadline for the minimum requirement.

The second reform to follow was the restructuring of… [END OF PREVIEW]

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