Discussion Paper No. 36 of 2004 on Capital Requirements and Bank Behaviour in Kenya: Empirical Evidence

Abstract

This study analyses the impact of risk-based capital requirements on bank risk and capital levels. In the past, regulators placed much attention on increase in bank capital without much consideration of the corresponding level of risk in bank portfolios. Theoretical and empirical research suggests that increasing regulatory capital standards may cause banks to increase rather than decrease portfolio risk. Furthermore, higher bank capital levels do not, by themselves, guarantee that banks are adequately capitalized. Therefore, from a public policy perspective, what is important is the amount of capital a bank holds relative to its level of risk. A major step towards this is the Basle Accord of 1988, which requires that capital requirements be sensitive to the risk in a bank’s portfolio of assets and off-balance sheet activities. Building on research done in other countries, this study utilizes simultaneous equations approach to model the regulatory impact of minimum capital requirements on bank risk behaviour and capital levels. The study uses data series for the first three years when risk-based capital requirements were enforced in Kenya. The study estimates using the three stage least square method, which is a full information estimation procedure.