The first Basel capital adequacy standard was signed by the Group of Ten countries in 1988 to improve the stability of internationally active banks and create a level playing field. The proposal received unexpected attention from around the world, and over 100 countries voluntarily adopted Basel I (Pattison, 2006). The standards were updated in 2004 with more sophisticated rules and principles (Basel II), and again in 2010 following the global financial crisis with enhanced capital, liquidity, and leverage requirements (Basel III). A survey conducted by the Financial Stability Institute shows that 95 out of 117 monitored non-Basel Committee member jurisdictions had adopted or were in the process of adopting Basel III as of mid-2015. This degree of interest suggests that Basel principles have become a model for bank regulators in both developed and developing countries.
The adoption of Basel principles by the majority of countries around the globe is significant. However, the Basel principles for capital regulation are complex, which gives countries substantial leeway in their implementation (Concetta Chiuri et al, 2002). For example, a country may announce the adoption of an 8 percent minimum capital ratio (the percentage of a bank’s capital compared with its risk-weighted assets) that is required by Basel rules. However, the effective stringency of this ratio will be determined by how the regulator of this country allows domestic banks to calculate the numerator (equity capital) and denominator (risk-weighted assets). That is, a regulator can loosely define the items that banks can include in their equity capital, or the risk weights in the denominator may not reflect a bank’s market or credit risk, contrary to the Basel recommendations.
Fortunately, a carefully executed survey series by the World Bank allows us to compare the actual implementation of Basel bank capital regulations across over 100 countries. The “Overall Capital Stringency” index in the surveys measures compliance with Basel guidelines regarding both risk weights and exclusion of certain market value losses from the regulatory capital (Barth et al, 2004). These surveys, conducted four times between 1999 and 2012, reveal that the stringency of bank capital regulations differs by significant amounts both across countries and over time for a given country.
In a recent FEDS Working Paper, Bank Capital Regulations Around the World: What Explains the Differences?, I investigate the empirical determinants of this variation based on theories of capital regulation and previous empirical studies. I develop testable hypotheses from the literature in order to investigate the effects of financial system structure and the economic, political and institutional characteristics of countries on the stringency of bank capital regulations.
The sample of my study includes a panel of 66 major countries, of which 21 are developed and 45 are developing economies. I show that countries with high average returns to investment or a higher ratio of government ownership of banks choose less stringent capital regulation standards. Higher returns make investment intermediated by the banking sector more attractive; hence, a regulator can allow more funds into risky projects by relaxing capital requirements (Kara, 2016). Government ownership of banks is used as a proxy for regulatory capture: the degree to which regulators are manipulated by the financial institutions under their control. This result implies that the stringency of capital regulations decreases with regulatory capture (Dell’Ariccia and Marquez, 2006). I also find some evidence that capital regulations are less stringent in countries with more concentrated banking sectors. A negative relationship between the stringency of capital regulations and concentration ratio would be obtained if regulators expect the banking sector to become more stable as it becomes more concentrated. Additionally, I do not find statistically significant effects of the depth, size, efficiency of financial markets, or institutional quality on the stringency of capital regulations. However, I find some evidence that countries with competitive and democratic political systems choose more stringent capital regulations.
Gazi I. Kara is a Senior Economist in the Financial Stability Division of the Board of Governors of the Federal Reserve System. The views expressed here are those of the author and do not necessarily reflect the views of the Federal Reserve Board of Governors or the Federal Reserve System.