Does Basel Save Our Banks? The Effect of Basel I Capital Requirements on Bank Failures

Abstract

We develop an empirical model to test the relation between compliance with Basel I capital requirements and the probability of bank failure during ‘normal’ economic conditions and times of financial crises. We also seek to determine whether increased capital requirements would further reduce the rate of bank failure. Specific bank data, as well as some macro-economic data, for the periods 1996-2007 and 2000-2007 are analyzed and multi-period logistic models are fitted to this data. Robust standard errors are used to ameliorate the issue of dependent observations. The results from the 1996-2007 sample should be taken with caution, given that the number of events for that period is relatively low.Banks that complied with the tier 1 and total capital requirements of the Basel I agreement saw their probability of failure drop significantly. The results also suggested that the Basel I capital requirements did not manifest procyclicality; to the contrary, they reduced failure rates even further in financial crises. In addition, the regression models indicate that increasing the tier 1 capital requirements would likely not be beneficial, although banks whose tier 1 capital ratio declined rapidly from one quarter to the next experienced increased risks of failure. A potential limitation of the models is that they utilize only data from US banks; whether the findings apply also to other developed nations is a question that requires further analysis.We conclude that the Basel I capital adequacy requirements achieve the objective of increasing banks’ financial stability and reducing bank failure rates. Importantly, the Basel I capital ratios appear to protect banks particularly well against insolvency in times of financial crises. Thus, our results do not support the argument that Basel’s requirements are procyclical. We find also that a rapid decrease in Basel capital ratios is a good indicator of a bank’s impending failure. Banking supervisors should therefore pay extra attention to these banks.