| Abstract: | Poor regulation and supervision have been noted as contributing factors to the recent financial crisis. The objective of banking regulation is to increase a bank’s solvency and liquidity in order to better absorb
financial and economic shocks and to create a stable financial sector. The “public interest view,” represented by governments acting on behalf of the public, strive to generate a stable financial sector, while the “private interest view,” represented by banks and lobbyists, claim that regulations impede
banking activities, its ability to be profitable and provide lending opportunities, thereby adversely impacting economic growth. Admati et al. (2010) argue that under higher capital regulations, banks would be able to make better, more socially optimal lending decisions, while maintaining the same
lending levels. Using this idea, this paper demonstrates that under regulatory standards that promote financial and economic stability, banks can still be profitable and engage in lending activities. Using an econometric model loosely based on Beltratti and Stulz (2012), bank-specific determinants (based on
Basel III recommended regulations) and regulation-specific determinants are used to determine the effect on bank profitability, thereby impacting a bank’s lending to support economic growth. The analysis was performed on systemically important banks in the period leading up to the 2007-09 financial crisis.
Overall, it was found that Tier 1 capital is positively related to bank profitability and leverage is negatively related to bank profitability. Interestingly, the deposit ratio is negatively related to profits and
the liquidity ratio is not significant. The results for the regulatory-specific determinants are conflicting regarding profitability. While the results imply that greater supervisory power implies higher bank
profitability, tighter restrictions on bank activities decrease profitability. The resulting estimated equation predicts that under Basel III regulations, banks can still be profitable, continue lending activities, and
contribute to economic growth. |