Modeling effects of banking regulations and supervisory practices on capital adequacy state transition in developing countries

Purpose - The FDIC Improvement Act of 1991 sets out five categories of capital and mandates corrective action for banks. Each bank based on its capital amount fall in the certain categories or states. The purpose of this paper is to consider the effect of banking regulations and supervisory practices on capital state transition. Design/methodology/approach - First, the authors investigate how much the practices influence banks' capital adequacy using a dynamic panel data method, the generalized method of moments. Then, to scrutinize the results of the first phase, the authors estimate the effect of practices on some characteristics of capital state transition such as transition intensity, transition probability and state sojourn time using multi-state models for panel data in 107 developing countries over the period 2000 to 2012. Findings - The dynamic regression results show that capital guidelines, supervisory power and supervisory structure can have significantly positive effects on the capital adequacy state. Moreover, the multi-state Markov panel data model estimation results show that the significantly positive-effect practices can change the capital state transition intensity considerably; for example, they can transmit the critical-under-capitalized (the lowest) capital state of banks directly to a well or the adequate-capitalized (the highest) capital state without passing through middle states (under-capitalized and significantly-undercapitalized). Moreover, the results present some new evidence on transition probability and state sojourn time. Originality/value - The main contribution of this paper, unlike the existing literature, is to consider the power of banking regulations and supervisory practices to improve the capital state using a multi-state Markov panel data model.