Credit Quality of Indian Banking Sector: Implications of Basel III Regulations

ABSTRACT In the last few years, due to a drastic increase in bad loans, the credit quality of banks has degraded in India. Along with national policies designed by banking regulator Reserve Bank of India (RBI) for management of credit quality, international best practices have also been implemented by the banking institutions. The Basel Accords proposed by the Basel committee have been provided for strengthening the banking sector and making it more resilient to any economic or financial shocks. Thus, the present study has been carried out with the objective to analyze the association between the recommendations of the most recent Accord by the Basel committee, that is, Basel III, and the credit quality of Indian banking industry. The study has undertaken a sample of 37 domestic commercial banks, examined over a time frame of 5 years (2015–2019). In order to address the endogeneity issue between capital regulations and credit quality representative, non-performing assets (NPA), the two-step system generalized method of moments has been applied for the purpose of regression analysis. The study has found that stringent capital requirements imposed by RBI are helpful in improving the credit quality of banks by reducing NPA. The results have further shown that the non-risk-based leverage ratio brings additional bad loans and, thus, bears an adverse influence on the asset quality of banks. The liquidity risk measure provided by Basel III, liquidity coverage ratio, does not carry any significant impact on NPA of domestic Indian banks. Results of the present study have implications for policymakers and bank management. Iinvestors can also benefit from the study. They can take the results presented on which banks are expected to be faced with a higher credit risk in future and the banking entities holding higher capital buffers which can protect the institutions from future loan losses.