Impact of Implementation Challenges of Capital Adequacy Ratio of Basel Accord II and III: Evidence from the Banking Sector of Pakistan.

Abstract

There are controversies in literature on how impositions of capital adequacy ratio (CAR) affect the bank behavior. In this context, present study analyzed the impact of CAR on the bank behavior in terms of risk taking, lending and profitability in the banking sector of Pakistan. For this purpose, present study used sample of 26 banks due to the availability of data on CAR for the period of 2005-2015. The study contributes in literature by extending Shrieves and Dhal (1992) model in Pakistani banking sector by using 2SLS and 3SLS techniques. The study also used Chami & Cosimano (2005) model and trade-off theory, by employing GMM technique to analyze the impact of CAR on the lending and profitability behavior of Pakistani banks. Results of the study confirm that CAR is effective in limiting risk-taking behavior of Pakistani banks which restrict their lending capacity for private sector in Pakistan. However, higher CAR leads to reduced cost of bankruptcy which improves the profitability position of Pakistani banks. Furthermore, the study also aims to identify the implementation challenges of advance approach of Basel Accord by using survey questionnaire. Results of the survey show key challenges such as lack of resources, credit and operational risk and supervisory review process however, proactive risk management culture positively contributes to the implementation process. The study has policy implications for the banks and regulators by providing them insights on the tradeoff of higher CAR and recommendations to overcome implementation issue of advance approaches of Basel Accord.