This paper intends to develop an Early Warning System (EWS) for predicting the future capital adequacy of commercial banks. Using the financial data for Indian public sector and private sector banks, binary choice models are estimated and bank-wise probability of future capital inadequacy (one year prior to the actual outcome) is generated. Perhaps not surprisingly, a number of banking indicators are found to be good short-term predictors of capital ratios. The EWS models developed in this paper could identify capital inadequate banks with a reasonable degree of accuracy. Thus, our models could be potentially useful as effective EWS for off-site surveillance of commercial banks.
Banking is deemed to be one of the most meticulously regulated and monitored sectors worldwide.
This fact reflects upon the sway banks hold over the macro economy. Banks play an important role in
the economy as savings institutions and as providers of credit and capital. Besides government
supervision, deposit insurance and other regulatory conditions, capital requirements limit risks for
depositors and other stakeholders and reduce insolvency and systemic risks. Excessive capital
requirements induce credit crunch, whereas inadequate capital requirements lead to undesirable
levels of systemic risk. With this backdrop, in 1988, the Basel I Accord was introduced which proposed
a uniform framework for the implementation of risk-based capital rules. However, this framework
applied the same “risk weight” to various credit exposures, regardless of their creditworthiness.
Consequently, the Basel Committee released the Basel II Accord which aimed at making the capital
requirements risk sensitive. Although capital adequacy is a necessary condition for ushering stability
in the banking sector, it needs to be supplemented with a sound monitoring and supervisory framework
for financial intermediaries. Central banks around the world have, therefore, started working towards
strengthening prudential norms and enforcing transparency in financial reporting and accountability
on the part of financial institutions to avert any future financial crisis.
The best way for supervisors to track the condition of banks is to conduct frequent, periodic on-site
examinations of banks. But examiners cannot be perpetually on-site at all banks—that would be
prohibitively expensive and, for most banks, unnecessary. As a result, supervisors also monitor bank
condition off-site. Off-site surveillance yields an ongoing picture of bank condition, enabling supervisorsto schedule and plan exams efficiently. Off-site surveillance also provides banks with incentives to
maintain safety and soundness between on-site visits. |
