Abstract
The capital to risk-weighted assets ratio (CRAR) introduced by the Basel Committee on Banking Supervision (BCBS) of the Bank for International Settlement (BIS) is widely used as an important measure of the soundness of banks. However, international institutions, academics, and market analytics have increasingly questioned the reliability of the ratio which has been revised a number of times since its inception, to make it more robust. The main objective of the present study is to assess the adequacy of using CRAR as a measure of the soundness of banks. One of the most popular methods used for the analysis of the banks’ financial soundness is CAMELS framework which uses six key dimensions: capital adequacy, asset quality, management quality, earning ability, liquidity, and sensitivity to market risk. Before the introduction of CRAR, the ratio of capital to the total assets was widely used as a measure of capital adequacy in the CAMELS framework. However, when risk-based CRAR was introduced, banking regulators and policymakers started using it in the CAMELS framework for representing capital adequacy. In this paper, we argue that CRAR, as a comprehensive forward-looking measure, encapsulates all the six dimensions of the financial soundness of banks, representing various facets of banking operations, which are covered in the CAMELS framework. We, therefore, develop a theoretical framework to establish the relationship between risk-based CRAR and the important ratios used under the CAMELS framework and then empirically investigate the relationship using a panel regression model using data of Indian banks for the period 2009–2018. The results indicate that CRAR has a significant and theoretically consistent relationship with all six dimensions of the CAMEL framework. The study, therefore, does not only confirm the appropriateness of using CRAR as a measure of the soundness of banks, but also opens up a debate on whether CRAR can be an alternative for the CAMELS framework.
Highlights
Banks play a crucial role in the development of a country
+β7 GAPTAi,t + μi + ∈i,t where CRAR is the capital to risk-weighted assets ratio, leverage ratio (LR) is the ratio of Tier-1 capital to the total exposure, Gross Nonperforming Assets (GNPA) is the gross nonperforming assets over the performing assets, IOTA is investments over the total assets, contingent liabilities to total assets (CLOTA) is the contingent liabilities over the total assets, OPOA is the operating profit over the total assets, LAOTA is the liquid assets over the total assets, and GAPTA is the sensitivity ratio measured as GAP over total assets
We examined the appropriateness of using CRAR as a measure of the financial soundness of banks by theoretically and empirically investigating the relationship between this risk based capital ratio and a set of financial ratios, which are commonly used under the CAMELS framework to assess the soundness of banks
Summary
Banks play a crucial role in the development of a country. Banks through the intermediation process mobilize savings, lend to various segments of the economy, and promote economic growth. The sustainability and growth of the banking sector are, very important for the development of the financial sector as well as for economic growth. The very nature of the banking business has many inherent risks, such as credit risk, market risk, operational risk, liquidity risk, etc. If any of these risks materialize and the bank incurs unexpected losses, it can adversely influence the stability of its banking operations. Banks have to be financially sound to sustain themselves and grow
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