Impact of Market Discipline on the Capital Adequacy of Banks: Evidence from an Emerging Economy

Abstract

This research paper presents empirical support to the role of market discipline in augmenting bank capital ratios in a competitive banking environment. Using a panel data set of domestic commercial banks in Pakistan from 2009-2014 the study analyses whether the market penalized banks for increase in their risk profile through a rise in cost of raising funds. The results find significant relationship between capital adequacy and other risk factors, with cost of deposits demonstrating how depositors align the required return to the perceived risk level of the bank. These findings have important implications for policy makers as the market discipline could compliment the role of regulators, which would eventually lead to a lower cost of supervision. Moreover the focus of international reform process as seen through implementation of Basle III, should continue to be on developing a more competitive and transparent banking system.