Base III and bank lending channel evidence in BRICS nad OECD countries

UNIVERSITY OF ECONOMICS
HO CHI MINH CITY

ERASMUS UNVERSITY ROTTERDAM
INSTITUTE OF SOCIAL STUDIES

VIETNAM

THE NETHERLANDS

VIETNAM – THE NETHERLANDS
PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

BASEL III AND BANK LENDING CHANNEL:
EVIDENCE IN BRICS AND OECD COUNTRIES

BY

NGUYEN THI HONG VAN

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

HO CHI MINH CITY, December 2017
i


UNIVERSITY OF ECONOMICS

INSTITUTE OF SOCIAL STUDIES

HO CHI MINH CITY

THE HAGUE

VIETNAM

THE NETHERLANDS

VIETNAM - NETHERLANDS
PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

BASEL III AND BANK LENDING CHANNEL:
EVIDENCE IN BRICS AND OECD COUNTRIES

A thesis submitted in partial fulfillment of the requirements for the degree of
MASTER OF ARTS IN DEVELOPMENT ECONOMICS

By

NGUYEN THI HONG VAN

Academic Supervisor:
LE HO AN CHAU

HO CHI MINH CITY, December 2017


DECLARATION
“I certify the content of this dissertation has not already been submitted for any degree
and is not being currently submitted for any other degrees. I certify that, to the best of my
knowledge, any help received in preparing this dissertation and all source used, have been

acknowledged in this dissertation.”
Signature

Nguyen Thi Hong Van
Date: December 15th 2017

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ACKNOWLEDGEMENT
Foremost, I would like to express my sincere gratitude to my supervisor Dr. Le Ho An
Chau, for her patience, motivation, enthusiasm, sympathy, immense knowledge, and for giving
me valuable advice. Her guidance helped me at all the time of research and writing of this thesis.
In addition my advisor, I would like to thank Prof. Nguyen Trong Hoai and Dr. Pham
Khanh Nam who have their expertise view with me, the valuable experience in research, and Dr.
Truong Dang Thuy who has provided the practical econometric technique, a valuable knowledge
in research.
Furthermore, I would also like to thank all lecturers and staff at the Vietnam Netherlands
Program who already supported me wholeheartedly during my studying time in there.
In particular, I would like to express my gratitude and affection towards my family,
especially my mother who sacrifices so much for this family, who always devotes all love and all
the best interest for me.

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ABSTRACT
Basel committee on banking supervision (BCBS) promulgated Basel III regulations with
more tightened operating conditions in the banking sector. This improvement of BCBS has
brought about a lot of arguments. Some researchers suppose that Basel III regulations raise the

marginal cost and reduce bank lending, but others believe Basel III regulations can improve the
banking system and increase the financial shocks absorbability. To investigate the impact of
Basel III on bank lending channel, this study utilizes data collected from 391 commercial banks
in 10 countries (BRICS and 5 countries of OECD) from 2011-2016.
The empirical results from three stages least square under generalized structural equation
model (GSEM) show that there is the disparity impact of Basel III regulations on bank lending
channel between BRICS and 5 countries of OECD. Specifically, there is the significant negative
impact of Basel III liquidity regulations and time dummy variable but no significant capital
regulation effects on bank lending channel in BRICS countries. The possible reason is that
capital ratios (Tier 1 ratio, Common equity tier 1 ratio, and leverage ratio) of commercial banks
in BRICS were higher than Basel III regulations in the period 2011-2016. They have not had too
much pressure on adapting capital requirements of Basel III regulations. In contrast, in the 5
countries of OECD, there are no evidence to prove time dummy variable and the liquidity
regulations effect on bank lending channel, nevertheless, the capital requirements of Basel III
have a significant negative impact on bank lending channel.
Keywords: Basel III, Bank lending channel, Capital requirements, Liquidity regulations,
BRICS, OECD.
JEL Classification: G32, G38, E52, E42.

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TABLE OF CONTENTS
DECLARATION ............................................................................................................................. i
ACKNOWLEDGEMENT .............................................................................................................. ii
ABSTRACT ................................................................................................................................... iii
TABLE OF CONTENTS ............................................................................................................... iv
LIST OF TABLE ........................................................................................................................... vi
LIST OF FIGURES ...................................................................................................................... vii
LIST OF ACRONYMS ............................................................................................................... viii

CHAPTER 1 INTRODUCTION .................................................................................................... 1
1.1. Problem statement. ............................................................................................................... 1
1.2. Research objectives: ............................................................................................................. 2
1.3. Research methodologies and data ........................................................................................ 3
1.4. Research contribution ........................................................................................................... 3
1.5. The thesis structure............................................................................................................... 3
CHAPTER 2 LITERATURE REVIEW ON BANK LENDING CHANNEL AND BASEL III
REGULATIONS............................................................................................................................. 5
2.1. Theoretical review on bank lending channel and Basel III regulations ............................... 5
2.1.1. Bank lending channel .................................................................................................... 5
2.1.2. Basel III on bank regulations ......................................................................................... 9
2.1.3. Basel III effects on bank lending channel ................................................................... 10
2.2. Empirical review on the effect of Basel III regulations on bank lending channel ............. 13
2.3. Hypothesis construction and the conceptual framework.................................................... 18
2.3.1. The conceptual framework .......................................................................................... 18
2.3.2. The hypothesis construction ........................................................................................ 18
CHAPTER 3 RESEARCH METHODOLOGY ........................................................................... 20
3.1. Data sources ....................................................................................................................... 20
3.2. Research methodology ....................................................................................................... 20
3.2.1. Model specification ..................................................................................................... 23
3.2.2. Measurement variables ................................................................................................ 26
CHAPTER 4 THE EMPIRICAL RESULTS ................................................................................ 29
4.1. Data descriptions ................................................................................................................ 29
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4.2. The impact of Basel III regulations on bank lending channel............................................ 36
4.2.1. The impact of Basel III regulations on bank lending channel in 10 countries ............ 36
4.2.1. The impact of Basel III regulations on bank lending channel in BRICS .................... 38
4.2.1. The impact of Basel III regulations on bank lending channel in 5 countries of OECD

............................................................................................................................................... 41
CHAPTER 5 CONCLUSIONS AND POLICY IMPLICATIONS .............................................. 44
5.1. Concluding remarks ........................................................................................................... 44
5.2. Policy implications ............................................................................................................. 45
5.3. The limitation and further researches ................................................................................. 45
REFERENCES ............................................................................................................................. 46
APPENDIX ................................................................................................................................... 54

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LIST OF TABLE
Table 3.1. The descriptions’ definition and measurement unit of variables ................................. 24
Table 4. 1 Descriptive statistics of variables ................................................................................ 29
Table 4. 2 The correlation table .................................................................................................... 35
Table 4. 3 Bank lending channel with each effect of Basel III regulations in total 10 countries . 37
Table 4. 4 Bank lending channel with each effect of Basel III regulations in BRICS ................. 38
Table 4. 5 Bank lending channel with each effect of Basel III regulations in 5 countries of OECD
....................................................................................................................................................... 41

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LIST OF FIGURES
Figure 2 1 The simplified measurement for NSFR ....................................................................... 12
Figure 2 2 Scenario to approach the NSFR .................................................................................. 13
Figure 2. 1 The conceptual framework ......................................................................................... 18
Figure 3. 1The recursive relationship ........................................................................................... 21
Figure 4. 1 The loan growth distribution of 10 countries from 2011 to 2016. ............................. 30
Figure 4. 2 The loan growth distribution of 5 countries in OECD from 2011 to 2016 ................ 31

Figure 4. 3 The loan growth distribution of BRICS from 2011 to 2016. ..................................... 31
Figure 4. 4 The interest income ratio distribution of 10 countries from 2011 to 2016 ................. 32
Figure 4. 5 The interest income ratio distribution of 5 countries in OECD from 2011 to 2016. .. 33
Figure 4. 6 The interest income ratio distribution of BRICS from 2011 to 2016. ........................ 33

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LIST OF ACRONYMS
3SLS

Three-Stage Least Square

BCBS

Basel committee on banking supervision

BIS

The Bank for International Settlement

BLC

Bank lending channel

BRICS

Brazil, Russia, India, China, South Africa

DSGE

Dynamic Stochastic General Equilibrium

ECM

Error Correction Model

GMM

Generalized Method of Moment

GSEM

Generalized Structural Equation Model

OECD

The Organisation for Economic Co-operation and Development

SVAR

Structural Vector Autoregressive

VAR

Vector Autoregressive

VECM

Vector Error Correction Model

viii


CHAPTER 1 INTRODUCTION
1.1. Problem statement.
The financial crisis of 2007-2008 began on Wall Street, New York, and then spread over
the global economy. After the financial crisis in 2008, many researchers and policymakers
recognize that the global financial crisis was caused by the weakness of banking systems.
Therefore, they propose that banks should reform to strengthen the financial system and
encourage more the prudent lending behavior in upturns. The Bank for International Settlements
(BIS)1 rapidly developed Basel2 III regulatory framework in 2009 which was upgraded from
Basel II with more focus on banking sector monitoring, change in the definition of bank capital,
capital requirements, risk coverage, leverage ratio and liquidity management. The regulations of
Basel III aim to raise the quality and quantity of banks’ regulatory capital base and to improve
the risk coverage of the banking sector (Bezoen, 2015). In addition, the enaction of Basel III
also conducts the new provisions of liquidity management. However, there has been a lot of the
controversy about the negative effect of raising capital requirements and liquidity regulations as
it may lead to a slow credit growth and choke off asset-price pressures before a crisis occurs. On
the other side, many authors argue that Basel III regulations have the positive impact on the
economic performance and fluctuations in long term. Hence, the BIS extend the point of time to
complete the applied process of Basel III from 2015 to 2019. However, Angelini et al. (2015)
argue that in long-term via Basel III regulations commercial banks can absorb the financial
shocks.
Whether the new framework of the Basel or the upgrade of the Basel II to the Basel III
induces the slow loan growth and harms the revival of the economy? To adopt the capital
requirements and liquidity regulations of Basel III, the commercial bank can adjust their balance
sheet by increasing the capital and decreasing the risk-weighted assets including lending volume.
The decreasing of lending volume leads to the increasing the lending rate. Angelini, Neri, and
1

The Bank for International Settlement (BIS) is the international financial organization to serve central banks in
their pursuit of monetary and financial stability, to foster international cooperation in those areas and to act as a bank
for central banks.
2
The Basel is the set of international banking regulations issued by BIS

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Panetta (2011), Modigliani and Miller (1958), suppose that higher requirement capital leads to
the higher marginal cost of loans, so the loan's interest will increase. Kashyap, Stein, and Hanson
(2010) find that the loan interest upper 6 basis point after applied Basel III for the United State’
banking system. Hence, Basel III regulations directly increase the loans interest income ratio and
decrease loans volume. Besides that, the loans interest income ratio increase leads to the
decreasing of bank volume. So the Basel III regulations induce decreasing the loans volume on
direct and indirect sign. Cosimano and Hakura (2011) suppose that the Basel III regulations
prevent the recovery of the economy after the financial crisis. However, Angelini et al., (2015)
argue that in long-term via Basel III regulations commercial banks can absorb the financial
shocks. As the instruments of the monetary policy, Basel III is examined in several dimensions,
and angles. The foundations of the international regulatory framework of the Basel III for banks
are capital requirements and liquidity regulations. On one hand, researchers investigate the
impact of Basel III on the capital requirement (Kashyap et al., 2010, Cosimano and Hakura 2011,
Howarth and Quaglia 2013). They prove the capital requirements of Basel III raise the bank
lending rate and reduce the bank loan volume. On the other hand, Basel III is studied in term of
the impact of the liquidity regulations on the economy (Giordana and Schumacher 2011, Bonner,
Van Lelyveld and Zymek 2015). They suppose that the liquidity regulations also have the same
impact on the economy as that of capital requirements. Empirical studies consider one sector of
Basel III the capital requirements or the liquidity regulations. This study considers Basel III by
combining these two sectors to measure the impact of both capital requirement and liquidity

regulations on the economic growth via bank lending channel.
In theory, monetary policy can be transmitted into the economy through several channels.
Basel III indirectly affects bank lending channel by increasing the marginal cost of the bank loan
(Giordana and Schumacher 2011). This thesis focuses on the impact of the Basel III on bank
lending channel for commercial banks in 10 member countries of the Basel committee during the
period from 2011 to 2016. Differentiate from previous studies, this paper employs both capital
requirements and liquidity regulators in Basel III and utilizes loans rate and loan growth as two
dependent variables to examine the volatility of the bank lending.
1.2. Research objectives:
The objective of this study is to investigate the bank lending channel effect of Basel III
on the economies via of 10 member countries belonging to the Basel Committee during the
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period 2011-2016. Specifically, this study aims to test the direct effect of two elements of Basel
III capital requirements and liquidity regulations on loan growth and indirect effect on loan
growth via lending rate. Thenceforth, we can figure out the accurate impact of Basel III on each
factor of bank lending channel.
In order to obtain these objectives, this study aims to seek the answers to the following
research questions:
Do new regulations on capital and liquidity in Basel III have any effect on the economy
via bank lending channel? If so, are the impacts negative or positive?
Which factors of Basel III, i.e the capital requirement or liquidity regulations have higher
marginal effects on the economies?
The answers from this study will provide important policy implication regarding the
argument on whether the expanding schedule of Basel III is the right decision?
1.3. Research methodologies and data
To investigate the direct and indirect impact of Basel III regulations on bank lending
channel, and solve the causality relationship between of loan growth and bank lending rate, this
study utilizes Three-Stage Least Square (3SLS) estimation based on Generalized Structural

Equation Modeling (GSEM). Besides that, this study employs time dummy variable to study if
the bank lending channel is different before and after applying Basel III regulations.
Data of this research is collected for 391 commercial banks in 10 countries (BRICS and 5
countries of OECD) from 2011-2016 from Orbis Bank Focus. Moreover, data for
macroeconomics variables are collected from World Bank and OECD database.
1.4. Research contribution
This study provides empirical evidence of the Basel III effects on member economies via
bank lending channel. The main contribution of this thesis is to analyze both direct and indirect
effects on the loan growth and lending rate, and address the endogeneity problem of these
variables. Additionally, this thesis examines the Basel III regulations more comprehensively in
both capital requirements and liquidity regulations dimensions and compare the difference
between two groups of countries: BRICS and OECD. The findings from this study will suggest
important policy implication for central banks.
1.5. The thesis structure
This thesis includes five chapters, which can briefly be presented as follow:
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Chapter 1 presents the problem statement and the overview of this study.
Chapter 2 presents the related theories and the empirical evidence with the focus on the
bank lending channel and Basel III regulations.
Chapter 3 discusses the research methodology, in which the formulated model and
explanations of data measurements are examined. In addition, the econometric technique for
research objectives will be clarified.
Chapter 4 presents the empirical results.
Chapter 5 presents the general findings and the discussions. The policy implications, the
limitations and the potential improvements for future studies are also discussed.

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CHAPTER 2 LITERATURE REVIEW ON BANK LENDING
CHANNEL AND BASEL III REGULATIONS
2.1. Theoretical review on bank lending channel and Basel III regulations
2.1.1. Bank lending channel.
2.1.1.1. The introduction of bank lending channel
Bank lending channel (BLC) is one of the supplement transmission channels of the credit
channel to strengthen the impact of the monetary policy on economic variables through bank
credit supply. In the money market, bank lending is the main capital market instrument to
mobilize capital. BLC approaches all of the elements in the economy for example households,
entrepreneurs, financial institutes, governments, etc. Moreover, commercial banks which provide
BLC into the economy occupies mainly the market share in the financial market. So, monetary
policymaker can promulgate policies to obtain their target via BLC. Bernanke and Blinder
(1988) indicate that if policy maker contracts the monetary policy, the credit supply also
decreases and vice versa.
Monetary policy ↓→ funds of commercial banks ↓→ credit supply ↓→ investment,
consumption ↓→ output ↓
The bank lending channel operates through the credit supply of the commercial bank, so
BLC complies some existed conditions in the economy, commercial bank, and customer
characteristic:
Firstly, enterprises depend on funds from the commercial bank and commercial banks
can’t replace entire funds from deposits (Bernanke & Blinder 1988). Bank loans hold mainly
position in the capital structure of the enterprises because firms can easily and fast approach
money from the bank with low cost than other funds. Besides that, enterprises can salvage the
financial leverage by using bank loans to get gain from tax shield. If firms won’t employ bank
loans, BLC won’t exit. Gomez-Gonzalez and Grosz (2006) indicate the small enterprises depend
to the capital from bank loans more than large firms, because of the lack access to securities
markets and banks have a comparative advantage in obtaining customers information than other
investors. Commercial banks are the financial intermediations, so deposits always hold major
capital of commercial banks. If commercial banks employ other funds instead of deposits, the

monetary policies can’t affect the credit supply (Bernanke & Gertler 1995).

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Secondly, the policies of the central bank can adjust bank lending supply of commercial
banks (Kashyap & Stein, 1994). It depends on many elements such as the level independence of
the central bank, creditability, transparency.
Besides that, monetary policy will be transmitted through bank lending channel, when the
reduction of long-term real interest income ratio is ineffective (Bernanke & Gertler, 1995).
Farinha and Robalo Marques (2001) suppose that BLC exists when banks cannot perfectly shield
transaction balances (deposits) from changes in reserves; and there are no close substitutes for
money in the conduct of transactions in the economy.
2.1.1.2. Determinants of bank lending channel
BLC is affected by both macroeconomic and microeconomic factors (Altunbas,
Gambacorta and Marques-Ibanez, 2010, Angeloni and Ehrmann, 2003). Policy rates affect bank
lending interest income ratio (Cottarelli and Kourelis, 1994, Mojon and Peersman, 2001, Sander
and Kleimeier-Ros, 2004, De Bondt et al., 2005, Berg et al., 2006). However, Berger and Udell,
(1992) indicate that the loans rates and credit supply of each commercial banks have a different
reaction to the volatility of policy rates because of different bank’s characteristics.
Macroeconomic conditions
The level wealth of bank lending channel transmission is different among countries
because of the differences in macroeconomic conditions. Mishra and Montiel (2013) suppose
that BLC exits in most of the developed and developing countries. However, BLC in the
developing countries is stronger than developed countries because of the weakness of the
international and domestic financial markets (Mishra, Montiel and Spilimbergo, 2014). In
developing countries, financial markets are inefficient so investors capture capital mainly via
bank loans, so central banks intervene deeply in bank loans (Mengesha and Holmes, 2013).
Consequently, BLC in developing countries is stronger than other channels. Conversely, BLC is
weaker in high – developed financial markets.

BLC depend on the economic openness of each country. If a country is less open, the
international financial markets will be weaker. Consequently, BLC is stronger than other
countries and vice versa. Escrivá and Haldane (1994) suppose that in the openness countries,
BLC may be weaker because of the impact of the external shock into the domestic economy. In
addition, BLC depend on the economic structure. In addition, Cecchetti (1999) suppose that BLC
is affected by the scale of the economy, the development of infrastructure. Juselius and Toro
6


(2005) find the evidence for the impact of volatility of the economic structure on BLC in Spain.
Moreover, BLC depend on public debt. Woodford (1990) suppose that the effective management
of public debt will help balance the inefficiency in the intermediate financial system. Besides
that, BLC depend on the degree of independence of central bank. Dornbusch, Favero and
Giavazzi (1998) indicate that BLC will be stronger when the central bank is more independence
because of the efficient transparency and accountability of central bank.
Banking regulations
The central banks manage and monitor capital mechanism via BLC. Commercial banks
directly react to the central bank regulations (Honda, 2004). Commercial banks can break safety
hurdles and join new riskier activities, when the central bank doesn’t consider risky actions of
commercial banks in monetary policy conducting (Zhu, 2007), this makes BLC stronger and vice
versa. In the late 1980s, the Basel banking supervision committee issued Basel I to create
minimum capital adequacy standard, then Basel II (2006) improve the safety regulations on
minimum capital adequacy. After that, Basel III (2010) focus on clarifying the capital definition,
raising the quality, quantitative of capital requirements and enact the new liquidity regulations
(BCBS, 2010).
BLC is affected by regulations on the interest income ratio. Central banks employ
regulations on interest income ratio mechanism via promulgating the ceiling on the interest
income ratio which prevents the excessive competition among commercial banks, limit the risky
investment activities of commercial banks. So the regulations on ceiling interest income ratio
would make BLC weaker. Mertens (2008), prove that BLC weaker when the United States apply

the ceiling interest income ratios.
The competition in banking sector
BLC will be weaker if the banking sector is less competitive (LeRoy, 2014). Fungáčová,
Solanko and Weill (2014) indicate that BLC will be stronger if banking sector is the monopoly
competitive market. And they also suppose that BLC will be weaker, if banking sector is the
oligopolistic market.
Microeconomic determinants
Besides macroeconomic determinants, microeconomic determinants also effect on BLC
(Bernanke and Blinder, 1988). BLC in different commercial banks is different because of the
difference of commercial bank characteristics: (i) the commercial banks’ size, (ii) the
7


commercial banks’ capital, (iii) the commercial banks’ liquidity, (iv) the commercial banks’ risk,
and (v) the commercial banks’ customer characteristics, etc.
The commercial banks’ size
BLC is weaker in large commercial banks. Larger commercial banks have a more
competitive advantage and powerful in the financial market. So they can tolerate any kind of
shock and the chance of monetary policy more easily, and their development is stable. In
contrast, small commercial banks have less competitive advantage and powerful in the financial
market, so they can be impacted by the volatility of the monetary policy (Kashyap and Stein,
2000, Altunbaş, Fazylov and Molyneux, 2002, Kakes and Sturm, 2002, Altunbas, Gambacorta
and Marques-Ibanez, 2012).
The commercial banks’ capital
The capital of commercial bank has the negative relationship with the bank lending
channel. The banking system would be healthier with the higher capital ratio (Mingo, 1977,
Mingo and Wolkowitz, 1977). However, raising capital ratio is equivalent to restricting the
fundraising. Consequently, the behavior of commercial bank behave is cutting loans supply
(Kishan and Opiela, 2000, Kishan and Opiela, 2006, Altunbaş, Fazylov and Molyneux, 2002).
The commercial banks’ liquidity

The liquidity of commercial bank has a negative impact on the bank lending channel.
Higher liquidity commercial bank has higher ability to fight against the economic shocks, so to
raise the commercial banks’ liquidity they reduce the liquidity risk and loans supply (Kashyap
and Stein, 1994). So, the asset of commercial bank more liquidity the bank lending channel
weaker (Peek and Rosengren, 1995).
The commercial banks’ risk
The risk of the commercial bank has a negative impact on the bank lending channel.
Hoshi and Kashyap (2000) indicate that banks’ risks restrict the loan supply because of their
flexibility. However, the commercial bank can pretermit the Moral Hazard issue to capture more
loans with higher risk (Krugman, 2008).
The commercial banks’ customer characteristics
The bank lending channel can be affected by their customer characteristics: (i) financial
barriers, (ii) borrowing capacity, (iii) and size of enterprises, etc. (Dedola and Lippi, 2005,
Peersman and Smets, 2002, Tena and Tremayne, 2009, Koop et al., 1996). Commercial banks
8


have more power to grant loans for small and medium enterprises (SMEs) because of their less
capacity to approach other capital sources and higher risk than large enterprises (Gertler and
Gilchrist, 1991, Gertler and Gilchrist, 1993, Mojon et al., 2002). When the borrowing capacity of
enterprises is lower, there are not many chances for them to capture the capital. So commercial
bank has more advantage to grant bank loans. If the customers have more financial barrier that
means their borrowing capacity is restricted. In that case, the bank lending channel will be
stronger (Dale and Haldane, 1995, Stoneman and Canepa, 2002).
2.1.2. Basel III on bank regulations
2.1.2.1. Basel III introduction
Basel III is the comprehensive set of reform measures for the international banking
system, upgraded from Basel II, when Basel Committee on Banking Supervision (BCBS)
perceives the deficiency of the previous version. Basel III was promulgated in 2009 after the
financial crisis in 2008. Perceiving the weak capital quality and liquidity in global banking

system mainly contributes to the financial crisis in 2008. BCBS upgraded Basel II to Basel III to
improve the health of banking system, increase the capability absorbing the financial shocks.
Basel III include the general operating criterions of the international banking system to increase
the quality and level of bank capital, strengthening the regulations in the banking sector and
strengthening overall risk management. Based on Basel III, commercial banks raise capital
requirements, leading to more resilient financial buffer (Admati and Pfleiderer, 2010). Besides
that, commercial banks must hold the more liquid asset, so the bank funding will be more stable.
Consequently, the risk of bank default is decreased. However, Basel III also damp on the
economic growth through the effect of bank lending channel (Angelini et al., 2011). Meanwhile,
the increased capital requirement, the marginal cost of using the capital of banking system
increase, so the bank lending reduction.
2.1.2.2. The chance of Basel III
Because of the unclear capital definition, lack liquidity management, and pro-cyclical
effect of Basel II, the Basel III regulations achieve two main objectives: (i) strengthen the
liquidity of banking system, (ii) raise the capability absorbing financial shocks. Basel III
regulations focus on clarifying the capital definition, tightening the capital requirement and
augmenting liquidity to prevent system risk. Specifically, Basel III regulations neglect the Tier 3

9


capital, raise the Tier 1 ratio, Common Tier 1 equity ratio, enact the Leverage ratio and Liquidity
Coverage ratio, and Net stable funding ratio.
New capital definition and requirements
Basel III regulations assert commercial banks raise their common equity including
common share and retained earnings. Basel III regulations abolish tier 3 capital and increase the
minimum of Tier 1 ratio from 4 percent to 6 percent. Simultaneously, the minimum of Common
equity tier 1 ratio also raises from 2 percent to 4.5 percent. Besides that, Basel III regulations
enact the new leverage requirement with the minimum of the leverage ratio is 3 percent. The
tightening capital requirements reduce the risk exposure, counterparty credit risk and raise the

capital buffer. However, to adapt the capital requirements commercial banks carry the higher
financial cost and lower shareholder’s profit.
New liquidity ratios
Basel III regulations enact new liquidity requirements mainly via liquidity coverage ratio
(LCR), and net stable funding ratio (NSFR). LCR is the criteria for holding liquid assets of the
commercial bank. The liquidity coverage ratio equals stock of high-quality liquidity assets to the
total net cash outflows over the next 30 calendar days. It expresses the magnitude of high
liquidity assets for each next 30 calendar days total net cash outflows unit. Basel committee on
banking supervision (BCBS) suggest bank should maintain LCR more than 100 percent, that
means bank should maintain the high-quality liquidity assets more than the total net cash
outflows over the next 30 calendar days. NSFR is the criteria for holding long-term assets of the
commercial bank. Under the liquidity requirements of Basel III regulations, commercial banks
can counteract the economics shocks and limit the liquidity risk. Angelini et al. (2015) suppose
that: “the net stable funding ratio addresses the maturity mismatches between bank’s assets and
liabilities”. The net stable funding ratio equals the available amount of stable funding over the
required amount of stable funding. Basel III regulations require commercial bank maintain
NSFR at least 100 percent, that means commercial bank have to hold the available amount of
stable funding more than the required amount of stable funding.
2.1.3. Basel III effects on bank lending channel
There are many researchers argue that the Basel III regulations have a negative impact on
recover economy. Basel III regulations tighten the commercial banks’ operating conditions on
capital and liquidity. These regulations raise the marginal cost of funding. So commercial banks
10


react by raising the bank lending rates and reducing the credit growth. When the credit growth
decreases, the investment and consumptions decrease. Consequently, the output decreases.
2.1.3.1. The effects of Basel III capital requirements on bank lending
Some recent studies have mentioned the cost channel when they study the bank lending
channel (Gaiotti and Secchi, 2006, Adolfson et al., 2005), it transmits monetary policy through

the effect of credit supply on lending interest income ratio and the effects on input capital cost
(Tillmann, 2008). Based on the Risk-adjusted rate of return on capital (RAROC), the marginal
cost of loans is measured by the equation (Cosimano and Hakura, 2011):
𝑀𝐶 =

𝐷
𝐴−𝐷
(𝑟𝐷 + 𝐶𝐷 ) + 𝐶𝐿 +
𝑟 (1)
𝐴
𝐴 𝐾
𝐾 ′ = 𝐴 − 𝐷 (2)

Where: MC is the total marginal cost, M is the marginal revenue, D is the deposit, A is
the total assets, rL is the loan rates, rD is the interest income ratio on deposits, rK is the return on
equity, CL is the cost of loans, CD is the cost of deposit, K is the capital, K’ is the future capital,
L is the bank loans.
The equation (1) expresses the component of marginal cost in commercial bank
operation. In particular, the equation (1) figure out the future capital fraction is a positive impact
on total marginal cost. That means, in case the return on equity constant, the capital fraction
increase, the total marginal cost also increase.
Basel III regulations raise the capital standards for commercial banks. Based on the
equation (1), the total marginal cost of commercial bank increases belongs to the higher capital
requirements.
Cosimano and Hakura (2011) also conduct the equation for loan rates:
𝑟𝐿 = 𝑏0 + 𝑏1 𝑟𝐷 + 𝑏2 (𝐶𝐿 + 𝐶𝐷 ) + 𝑏3

𝐾′
+ 𝑏4 log(𝐴) + 𝑏5 𝑀 + 𝜀1 (3)
𝐴

The demand for loans:
𝐿 = 𝑐0 − 𝑐1 𝑟𝐿 + 𝑐2 𝑀 + ε2 (4)
As the equation (3), an increase in capital fraction would lead to increase the loan rates.
And the equation (4) shows that the increase in loan rates would lead to decrease the bank loans.
Barth III and Ramey (2002) argued that monetary policy not only effects on demand side but
also on the supply side of the economy through the cost channel. The change in monetary policy
will alter the credit supply and lending rates of commercial banks. This process alters the
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marginal product cost and then affects output prices of enterprises (Chowdhury et al., 2006,
Ravenna and Walsh, 2006). However, the transmission of the cost channel is different between
industries. Barth III and Ramey (2002) found that the cost channel is the most important channel
in some industries in the United Kingdom due to these sector characteristics. That is consistent
with the study of Dedola and Lippi (2005), they found that sector characteristics affect monetary
policy transmission, and GDP is affected by impacts of monetary policy on both sides of supply
and demand. The existence of the cost channel greatly affects the optimal monetary policy
(Ravenna and Walsh, 2006). Because any change in monetary policy that transmits through IRC
and BLC may well be destroyed if a cost channel exists. So central bank is argued to keep a
stable policy in monetary policy conducting (Chowdhury et al., 2006).
2.1.3.2. The effects of Basel III liquidity regulations on bank lending
The liquidity requirements for commercial banks are the regulations which require
commercial banks have the ability to repay their liabilities immediately. Basel III regulations
introduce two new factors (LCR and NSFR) to indicate the liquidity regulations for commercial
banks. LCR expresses the magnitude of high liquidity assets for each next 30 calendar days total
net cash outflows unit. NSFR is the criteria for holding long-term assets of the commercial bank.
King (2010) conduct the simplified measurement for NSFR as the equation (5):

Figure 2 3 The simplified measurement for NSFR

To approach the NSFR, the commercial bank can increase Tier 1 capital, lengthen the
maturity of debt, raise holdings of high-quality investments, increase investments as a share of
total assets, increase cash as a share of total assets. Moreover, the commercial bank can reduce
maturity of loans to corporates and retail to less than one year, reduce liabilities, reduce all other
assets, issue debt and purchase government bond (King, 2010). These options direct decrease the
bank loans and indirect decrease the bank loans via raising the marginal cost of funding.
Figure 2.2. expresses the solution for commercial banks to approach the NSFR
requirement with the least strategies of cost-benefit analysis (King, 2010).

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Source: King (2010)
Figure 2 4 Scenario to approach the NSFR
2.2. Empirical review on the effect of Basel III regulations on bank lending channel
During the financial crisis in 2008, commercial banks reduce new loans because of the
stresses on bank liquidity (Ivashina and Scharfstein, 2010) and weak capital health (Demirguc Kunt, Detragiache, and Merrouche, 2013). After that, BCBS promulgated the upgrade version
for Basel namely Basel II with more tightening the quality and quantitative capital requirements
and introduce new liquidity regulations. More tightening in capital structure and liquid asset
would increase the economic shocks absorbing capacity. Miles, Yang, and Marcheggiano, (2013)
suppose that under Basel III framework capital requirements assert commercial banks raise their
equity, then commercial banks have more cash for lending. However, the lending spread would
increase, and negative impact on bank lending volume (King, 2010). There are many empirical
researches study the impact of capital requirement on bank lending channel. Cosimano and
Hakura (2011) examine the effect of Basel III new capital requirements on bank lending channel
(bank lending rates and loan growth). By using GMM estimations for 100 commercial banks and
bank holding companies from 2001 to 2009, their results show that the new capital requirements
will raise the cost to commercial banks, bank holding companies and borrowers lead to the
increase of the loan interest income ratio and reducing the loan growth. Francis and Osborne
(2012) indicate the capital requirements for banks in the United Kingdom harm on loan growth.

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Sutorova and Teplý, (2013) also indicate that commercial banks in the European Union have a
negative impact on bank volume after applying Basel III regulations. Blundell-Wignall and
Atkinson, (2010) indicate that Basel III regulations don’t handle the core issues of commercial
banks at that time, it just moves the risk buckets around with the derivatives to capture the capital
requirements.
There are many researchers studying the impact of Basel III liquidity regulations on bank
lending channel. Giordana and Schumacher, (2011) study the impact of Basel III liquidity
regulations on bank lending channel. By employing the Generalized Method of Moment (GMM)
for the commercial bank in Luxembourg, they indicate that both Net Stable Funding Ratio and
Liquidity Coverage Ratio make reducing on bank lending channel. Therein, the Net Stable
Funding ratio reduces bank lending channel more than the Liquidity Coverage Ratio. Gunji et al.
(2010) consider the impact of the monetary policy on the bank lending for the different scale of
Chinese bank from 1985 to 2007. They mention that under the monetary policy, the banks’ size
and banks’ liquidity significant impact on bank lending. But the capital of bank does not impact
on the bank lending with the varying monetary policy. Van den End & Kruidhof (2013)
investigate the systemic implications of the Liquidity Coverage Ratio and the bank reactions
under the Basel III liquidity regulations. As the results, they aware that lower liquid assets in the
buffer, more benefit for the macroprudential instrument. Their results prove that the Liquidity
regulations of the Basel II might be not effective, and have the adverse side effect during times
of stress. Bonner, Van Lelyveld, & Zymek (2015) study the determinants of the banks’ liquidity
holdings with a combination of bank-specific and country-specific variables for 7000 banks from
25 OECD countries. Their results show that the bank-specific and the country-specific
determined the liquidity of the banks without the liquidity regulation of the international
regulations. In addition, they figure out that higher liquidity buffers lower the lending volumes
and higher interest income ratios. Duijm & Wierts (2016) examine the relationship between the
new liquidity regulations under the Basel III and the bank balance sheet for banks in Dutch from
2003 to 2013. They figure out that to adopt the new liquidity regulations, the banks prefer

adjusting the liabilities side than the assets side of the balance sheet. In addition, their finding
point to the significant role of secured financing for explaining the leverage and liquidity cycle.
Most of the empirical studies on the Basel III regulations and bank lending channel
converge in the developed countries. At country level, For instance, Furfine (2000) examines the
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bank's loan portfolios adjustment to adopt the regulatory minimum capital requirements, the
relationship between the bank capital levels and lending with the sample from the commercial
banks in the United States from 1989 to 1997. The author indicates the capital requirement have
a negative impact on the bank loans demand and loan growth. Francis & Osborne (2009, 2012)
study the relationship of banks’ capital regulation on credit supply in the United Kingdom. They
also indicate that the higher capital requirements constrain the growth of credit. Gunji et al.
(2010) consider the impact of the monetary policy on the bank lending for the different scale of
Chinese bank from 1985 to 2007. They mention that under the monetary policy, the banks’ size
and banks’ liquidity significant impact on bank lending. But the capital of bank does not impact
on the bank lending with the varying monetary policy. Giordana & Schumacher (2011) study the
impact of the Basel III liquidity regulations on the Bank lending channel for banks in
Luxembourg from 2003 to 2010. They employ the Liquidity Coverage Ratio and the Net Stable
Funding ratio as two proxies of the Basel Liquidity regulations. Besides that, they add banks’
characteristics: the total loans of the bank, shares of the total assets, the monetary indicators: the
first difference of the nominal short-term interest income ratio, output gap, the dummy variables
for the last liquidity period as the controls variable to avoid the heteroskedasticity. Their findings
indicate the new liquidity regulations of the Basel III reduce the Banking lending channel.
However, the liquidity regulations of the Basel III also enhance the reaction of banks to the
monetary policy shock or the economic shock. Cosimano & Hakura (2011) investigates the
impact of the new capital requirement of Basel III on the bank lending channel via bank lending
rate and loan growth for bank holding companies from 2001-2009 in Japan, Denmark, and the
United States. Under GMM estimation results, they suppose that the marginal cost of funding
will increase when capital requirements for banks are higher. The banks’ reaction on bank

lending channel varies in the different countries. Francis & Osborne (2012) study the relationship
between the bank’s capital, bank’s lending and the bank’s balance sheet management behavior
for bank firms in the United Kingdom from 1996-2007. Their results point out that the capital
requirements change the bank’s capital and the bank’s lending lean on the disparity of the actual
and the target ratio. Šútorová & Teplý (2014) study the Basel III regulations in European from
2005-2011. They suppose that the new regulations of Basel III constrain the credit growth and
negatively impact on the European bank value. Bezoen (2015) investigate the impact of Basel III
regulations on bank lending channel in the European banks from 2009-2013. He examines the
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