Caveats When increasing the Paid-Up Capital Requirement for Commercial Banks in Developing Countries: A Study of Nepalese Banks

Abstract

Purpose: The minimum paid-up capital or common stock requirement has been increased for commercial banks in several developing economies, to strengthening their banking systems. This has led to consolidations and an increase in the lending capacity of banks. The literature is not clear on how the significant expansion in the size of a bank through consolidation impacts the profitability of a bank. In this work, we investigate the case of Nepalese commercial banks where paid-up capital requirements for commercial banks increased fourfold. Specifically, we investigate if operating profitability was impacted by different factors before and after the mandated increase. Design/methodology/approach: We collected financial data on six different large Nepalese banks, over a 10-year period for each bank, from their public financial statements. A panel data analysis was conducted on this sample of 60 observations, over two separate time periods: the pre-mandate period from 2007-2014 and the post-period from 2015-2017. Panel data regression was performed using the PLM package on the R data analysis platform. Findings: We find that credit exposure of banks had a positive impact on operating profit both pre and post mandate. However, non-performing loans did not impact operating profit prior to the mandated increase, but had a significant negative impact after the increase in paid-up capital requirements. Research limitations/implications: The theoretical contribution of this work is an analysis of the effect of increasing minimum capital requirements rapidly and significantly on commercial banks in a developing economy. We find that the expected consolidation of banks and increase in number of loans leads to greater credit risk assumed by the banks, even if non-performing assets were not a factor earlier, as was the case in our sample. Practical Implications: Increases in capital adequacy requirements as a result of Basel 2 and 3 must be implemented gradually, so that lending strategies by bank management have time to adapt to the larger volume of loans, especially in economies where non-performing assets are already negatively affecting financial performance. Resources should also be provided to ensure that localized knowledge specific to lending practices is not lost in the bank consolidation that follows.Social Implications: Local lending practices are an important driver of operational excellence in developing economies. Mandated mergers can lead to a loss of organizational knowledge and create a greater distance between the institution and the local borrowers in the community. This leads to greater non-performing loans which can negatively impact the operating profit of the bank. Originality/value: To the authors‟ knowledge, this is the first study to use panel data analysis to analyze the impact of lending practices on operating profitability both pre and post a mandated increase in paid-up capital or common stock requirements for commercial banks in a developing economy. Our findings offer prescriptive guidelines for future implementations of this policy in other economies.