HASSAN KITENDA: What effect will an increase in paid up capital have on commercial banks?

Capital acts as that cushion that protects banks, their customers, and shareholders against possible losses from risks that banks are exposed to. Traditionally, the core function of any commercial bank is the extension of loans and the larger proportion of banks’ assets is formed by loans.

This function is well executed only when banks have adequate levels of capital. Put simply bank capital can be defined as money that the bank has obtained from its shareholders and any profit it has made and it hasn’t paid out. Recently the Bank of Uganda has proposed that the paid up capital of commercial banks be increased from Shs25b to Shs150b. Furthermore, the paid up capital for tier II credit institutions will increase from Shs1b to Shs25b.

Microfinance deposit taking institutions, capital requirements will also increase from Shs500m to Shs10b. Currently, there is an ongoing debate on whether such an increase in capital requirements really benefits the banking sector and the economy as a whole or it will severely affect financial intuitions in the country.

What could be some of the benefits of increasing the paid up capital for commercial banks?

The increase in capital requirements will force banks to revisit their internal operation strategies in terms of strong corporate governance, risk assessment methods, and credit evaluation procedures hence reducing the bank’s credit risk that mainly affects Ugandan banks.

Well, banks with more capital are financially able to explore profitable projects, expand operations and take on well estimated levels of risks, while those banks with limited capital refrain from investing large sums of money in lending activities, which is risky.

It can be argued that well-capitalized banks react less to output shocks as compared to less-capitalized banks because they hold excess capital and need a little adjustment in lending during economic downfalls and in addition their profits are less sensitive to business cycles.

Commercial banks that are highly capitalized tend to have a buffer against financial costs of financial distress thereby reducing the probability of bank insolvency. 

Well capitalized banks improve the capacity of banks to raise funding, compete more effectively for deposits and loans, and better protect them from deposit risk when economic conditions deteriorate. It can also be argued that better-capitalized banks face lower funding costs, allowing them to increase lending.

An increase in capitalisation will force small banks to merge this will contribute to an increase in the number of products offered, integrated technologies, reduction of operational risks, increased market share which will improve bank stability. 

With enough capital, a bank may be able to handle major losses by cutting dividends, liquidating a fraction of its safe assets, and injecting new capital.

So, what could be the possible costs of higher capital regulations on commercial banks?

Commercial banks can cut their total lending. It has been evidenced that banks trying to satisfy more stringent capital requirements reduce their supply of credit and this leads to a slowdown in economic growth.

It should be known that when the central bank increases the core capital banks will face a notable reduction of the loan book. However, afterward, the quality of the loan book may either improve or worsen.

The larger banks are better able to increase their capital higher minimums will reduce competition in the banking industry, which can result in less efficient intermediation in the form of higher borrowing costs.

More potential competitors will be prevented from forming due to the high capital requirements higher capital requirements might protect existing banks by giving them more market power to raise loan rates, account fees, and other costs for their customers.

With an increase in severe competition in the banking industry, an increase in the minimum capital requirement might increase lending rates, and this will diminish bank profitability in the long run.

In conclusion, the biggest test for regulators will be how to identify how banks respond in practice to regulatory changes and to adapt to these regulations in such a way that banks risk-taking incentives are best aligned with those of the regulators. Further, the undercapitalized banks will have to gradually increase their capital or reduce their risky assets to meet the regulatory capital requirements. 

Hassan Kitenda is an equity and fixed income analyst

Email; hkitenda@outlook.com.