Determinants of Capital Adequacy Ratios Under Basel III: Stress Testing and Sensitivity Analysis on Egyptian Banks

Abstract

The objective of this paper is to (a) present an empirical evidence that explains bank internal financial ratios that influence capital adequacy ratio, (b) stress testing the impact of Basel III capital adequacy requirements on Egyptian banks, and (c) offer a road map, through a sensitivity analysis, to bank management regarding the implementation of the stress tests results. The data covers the period from 2010 to 2014 on a quarterly basis. The discriminant analysis is used for testing the robustness of the estimation. Stress testing is utilized based on the estimates the variables that meet Basel III new requirements of Capital adequacy ratio.The results show that (a) return on assets, return on equity, and asset-based market share have significant effects on capital adequacy ratio, (b) the ratios of loans/deposits and non-performing loans have positive significant effects on capital adequacy ratio, (c) the liquidity ratio in US $ has trivial effect on capital adequacy ratio, (d) liquidity ratio in Egyptian pound has insignificant effect on capital adequacy ratio, (e) the ratios of loans/deposits, non-performing loans and liquidity in U.S. $ are robust and significance determinants of capital adequacy ratio. In terms of stress testing, the results show that (a) the average optimal value for loans/deposit ratio is expected to increase to 0.7807 from the current level of 0.4663, (b) the average optimal value for non-performing loans is expected to increase to 0.2174 from the current level of 0.1010 and (c) the average optimal value for liquidity ratio in U.S $ is expected to increase to 1.0 from its current level of 0.5383.