In the aftermath of the global financial crisis of 2007-2009, tighter capital requirements for banks were identified as one of the ways to prevent a recurrence. Besides the statutory capital requirements, banks were required to hold discretionary capital as a counter cyclical buffer. The idea was that more capital by the shareholders will make the banks more resilient to financial shocks, including internal mistakes and errors. This in turn would increase banking sector stability. In any case in the event of financial turbulence, shareholder funds would be available to absorb the losses and depositor’s money would be protected.
Capital is perhaps the most important concept in banking and the near preoccupation with it among regulators since the financial crisis underlines it critical role. It represents that part of the bank’s asset which do not need to be repaid and in fact that the bank can afford to lose. Take for instance a bank that has Sh1 billion as outstanding loans. To be able to lend this amount, the bank borrowed Sh800 million from depositors and Sh200 million was contributed by the bank owners as capital. If Sh150 million of loans were not repaid, there would be enough money to pay back the depositors. Although the bank owners would suffer the loss, this is considered a private matter. However, if the bank had borrowed a higher amount such as Sh900 million instead with only Sh100 million from bank owners, the owners’ funds would not be adequate to cushion the depositors from unpaid loans of Sh150 million. Instead depositors would stand to lose Sh50 million, which is the difference between the capital contribution by the owners and the unpaid loans. A key role of the regulator is to protect depositors and there is near consensus that higher capital requirement provides a strong cushion.
In the Finance Act (2008), Central Bank increased the minimum capital requirement for banks from Sh250 million to Sh1 billion as from 2012, a fourfold increase in four years. Besides creating financial stability, higher capital requirements were expected to increase the economies of scale for bank operations thus lower transaction costs. More important was the expectation that it would also benefit the perennial problem of high lending rates, thus making credit more affordable to individuals and businesses. Whether the expected benefits were realised is not obvious. However, research has shown that while there is consensus that higher capital requirements promote bank stability and will be instrumental in avoiding a recurrence of a financial crisis, they come at a considerable cost.
The benefits of higher capital requirements are not free and come at a cost which is more likely to be passed on to the market. Determining the right minimum capital requirements therefore necessitates a careful balancing of the stability benefits against the economic costs that come with it.
The Finance Bill 2015 proposes a further progressive increase in core capital for the banking industry from Sh1 billion to Sh5 billion by end of 2018. The capital will be increased from Sh2 billion by end of 2016, then to Sh3.5 billion by end of 2017 and finally to Sh5 billion by end of 2018. While many banks already hold significantly higher capital levels, there are tier three banks that will need to either raise more capital from shareholders or merge altogether. There is also the option to move to microfinance bank status that has less capital requirements.
Generally capital is viewed to be more expensive than other forms of funding and for lower tier banks, the incentive is to minimise its usage within the constraints of regulation and operational objectives.
For one, raising capital is costly because the extra capital increases the downside risks for bank owners. Put another way, the more capital bank owners have put in a bank, the more they have to lose should the bank make loses or close. They are therefore more likely to demand a higher return for the extra capital that they put at risk. Besides, such capital may not be deployed immediately by way of lending and that brings in the cost of holding idle cash. This high cost of capital can be passed on to borrowers in the form of higher lending rates, at least in the short to medium term. This reduces credit demand and access for the most bank-dependent borrowers such as small businesses.
Secondly, an increase in owners’ capital may reduce the reliance on the cheaper depositor’s funds and is therefore more expensive. Debt and depositor funding enjoy tax advantages because interest expense is tax deductible while dividend paid to shareholders is not. Besides deposit funding is far cheaper, with a bulk of amounts held in current accounts not earning any interest. Much of the cost of deposit funding comes from implicit costs of branch networks, advertising, etc that are significantly lower than the required shareholder returns.
While predicting the response to the increase in minimum capital requirement is complex, the change in loan pricing equations is almost inevitable. Most lower-tier banks operate within specific niches, often providing flexible financial solutions to small and medium enterprises that may not be accommodated by the larger less flexible banks.
The option to move into the microfinance bank status that has less stringent regulation has the potential to move risky transactions out of the regulators view. There is also the risk of moving banking activity into institutions and financial arrangements that are not regulated, creating “shadow banking” that can be a recipe for creating massive problems and triggering future crisis such as pyramid schemes and shylocks.
While the increase in the minimum capital requirement is good for financial stability, it comes at a cost which is potentially significant. Whether the costs could outweigh the benefits and at what level of capital may be highly debatable. It is however important to recognise that there are trade-offs in raising minimum capital requirements for banking business.