The Impact of Business Cycle on Banks’ Capital Buffer, Risk and Efficiency: A Dynamic GMM Approach from a Developing Economy

Abstract

This article applies the generalized method of moments (GMM) to examine the relationship between capital buffer, risk and efficiency adjustments over the macroeconomic cycles. Using a panel dataset of 32 Bangladeshi commercial banks over the period from 2000 to 2014, we find an inverse relationship between the business cycle and capital buffers, while a positive relationship between the business cycle and bank risk. These findings support the implementation of countercyclical capital buffers in Basel III Accord to ensure bank safety during economic downturns. We also observe that the bank efficiency positively responds to macroeconomic fluctuations. While examining the impact of capital buffers on bank behaviour, we find that low buffer banks raise the level of capital buffers and improve the efficiency over time. In contrast, high buffer banks incline to raise investment in risky projects by deterioration of capital ratios during economic upturns. In this case, high buffer banks in developing countries should take risk and efficiency issues into great consideration and force low capitalized banks to follow the Basel III guidelines more stringently to adjust capital buffers, risk and efficiency with macroeconomic bounce. Also, developing countries, regulatory bodies are adopting and implementing Basel guidelines slowly, and thus it has volunteer impact on the buffer, risk and efficiency adjustments. So the regulatory bodies should be adapted the global financial changes that will be enhanced country’s financial market.

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