Capital requirements and bank behaviour: an empirical analysis of Indian public sector banks

Consequent upon the introduction of prudential norms as an integral part of financial sector reforms, the present paper investigates the relationship between changes in risk and capital in the Indian banking sector. A dynamic, multivariate panel regression model is formulated wherein changes in capital ratio depend on its lagged value, a range of conditioning variables and regulatory dummies. Our analysis reveals that: (i) the regulatory framework needs to be designed to encourage individual banks to maintain higher than stipulated capital levels to reflect their differential risk profiles; and (ii) there is no conclusive evidence of risk aversion among Indian banks.