Abstract
Using dynamic panel data models, and addressing a common inappropriate use of simultaneous equation models in the literature, we examine the effect of capital requirements on banks’ behaviour in Indonesia. We find that banks tend to comply with capital requirements by increasing their capital ratios when the ratios are lower than, or falling towards, the 8% regulatory minimum. However, our results are mostly driven by large private-domestic banks and heavily undercapitalized banks that were closely monitored by the regulator in the aftermath of the 1998 crisis. Therefore, whether in normal circumstances banks in Indonesia comply with capital requirements remains questionable.
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