Market Discipline, Capital Adequacy

The policy debate with regard to financial intermediaries has focused on whether, and to what extent, governments should impose capital adequacy requirements on banks, or alternately, whether market forces could also ensure the stability of banking systems. This paper contributes to the debate by showing how market forces may motivate banks to select high capital adequacy ratios as a means of lowering their borrowing costs. If the effect of competition among banks is strong, then it may overcome the tendency for bank under-capitalisation that arises from systemic effects. If systemic effects are strong, regulation is required. An empirical test for Indian public sector banks during the 1990s demonstrates that better capitalised banks experienced lower borrowing costs. These findings suggest that ongoing reform efforts at the international level should primarily focus on increasing transparency and strengthening competition among banks.