Interdependencies between regulatory capital, credit extension and economic growth

Abstract

Since the introduction of the third Basel Accord (Basel III) in 2011, there have been debatable outcomes regarding the effects of increased regulatory capital on economic growth. We aim to add clarity to some of these debates by investigating one primary channel through which regulatory capital may affect economic growth, viz. credit extension to the private sector. We capture credit extension through four dimensions, namely: bank credit to the private sector, bank credit to households, bank credit to firms, and bank credit-to-deposit ratio. The latter we use as a metric to capture funding (in)stability. We use a panel vector autoregression (pVAR) model on a sample of 124 countries, across the period 1998–2015 and analyse impulse response functions and forecast error variance decompositions to investigate the interdependence of regulatory capital, credit extension, and GDP growth. Our results indicate that regulatory capital reduces unstable credit (credit that may induce economic distress) while improving GDP growth. Simultaneously, such unstable credit shows negative effects on GDP growth. From this evidence, we infer that regulatory capital can induce funding stability within banking sectors, which can encourage sustainable economic growth. This provides strong support for the Basel III changes which have put more emphasis on Tier 1 capital and stable funding.