Do capital requirements affect cost of intermediation?: Evidence from a panel of South African banks

In the wake of the 2007 sub-prime financial crisis, global measures under the Basel Accord framework were taken to guarantee the preservation of adequate capital for the stability of the banking industry and to prevent another banking crisis. As a result, world bank capital ratios have increased. The primary objective of this paper is to investigate the impact of increased bank capital requirements in general and in particular those introduced under Basel II on the cost of intermediation in South Africa. Empirical evidence on the nexus between capital requirements and intermediation costs has significant implications on the lending market and therefore on the growth prospects of a country. Furthermore, higher intermediation costs undermines efforts towards financial inclusion particularly in South Africa where broader access to bank services for all remains a critical factor for redressing the challenges of high income inequalities. Utilizing annual bank-level data obtained from Bankscope for the period 2001 – 2012, the fixed effects estimation technique is applied on a balanced panel of ten banks constituting inter alia the four largest South African banks. For robustness, two alternative cost of intermediation variables are chosen, NIM1 which is net interest revenue to interest earning assets ratio while NIM2 is net interest revenue to average total assets ratio. Two proxy measures of capital requirements are employed namely the equity-to-total-assets ratio and a Basel II dummy variable to take the value one in 2008 and subsequent periods and zero otherwise. In addition to these variables, a number of bank-specific and macroeconomic variables that are hypothesized to influence the basic functions of banks are incorporated into the model. The results from estimating the fixed effects model show that a one percent increase in capital requirements lead on average to a range of 12 – 14 basis points increase in the cost of intermediation during the period of analysis. Empirical evidence from the study also indicate that the Basel II capital requirements effected in January 2008 contributed to increased cost of intermediation by an average 7 basis points for the period 2008 – 2012. We conclude that high capital requirements are associated with increased costs of intermediation. We therefore caution that while maintaining adequate capital levels is crucial for obvious reasons, there is need for supervisory authorities to ensure that such regulation is effective and well-balanced to guarantee safety and stability of the sector without endangering the ability of the banks to service the economy.