Banks may be paying for prudence with higher bad-loan ratios, according to a new study showing that stricter international capital rules increase bad debts and suggesting blanket rules risk backfiring.
Published by Trust Mpofu, an academic economist in the School of Economics at the University of Cape Town and published on the Reserve Bank website, the working paper found that tougher capital requirements under Basel II and III were linked to higher bad-loan ratios across seven major SA banks.
Only mid-tier banks bucked the trend, recording improvements in asset quality under tighter requirements, Mpofu said in the paper that breaks new ground as the first to link SA’s Basel regime directly to loan quality.
Mpofu, whose paper also showed bad debts had been on an increase since 2017, when capital requirements tightened across the board, said banks, on average, responded by extending lucrative but riskier loans, driving up bad debts.
“This result suggests that banks make more risky loans as capital regulations become stricter,” he said, referring to estimates of an econometric technique called Generalised Method of Moments, which lets researchers draw causal inferences from panel data rife with persistence and feedback loops.
Mpofu’s findings expose a perverse outcome under Basel rules II and III, which emerged in the aftermath of the 2008 global financial crisis as a regulatory antidote to the excesses of casino-style bets, where banks leveraged thin capital buffers to chase high-risk, high-return bets.
“In terms of policymaking, these results suggest that capital regulations alone may not be adequate to control problem loans,” said Mpofu, whose paper drew on 20 years of granular bank-level data (2000-2022) to isolate the effects of Basel II and III on banks’ credit books.
The findings come as the Prudential Authority, the deputy governor Fundi Tshazibana-led banking supervision of the Reserve Bank, pushes through the finishing touches of the Basel III endgame package, which was agreed in 2017 as the final iteration that completes the post-2008 overhaul of bank capital and risk weights.
In its latest annual report, the Prudential Authority said the final standards, including revised credit risks, and a standardised approach for day-to-day risk and extra Pillar 3 disclosures, would add about R6bn more capital cushion by the start of next year, driven largely by the new operational risk charge.
Under the overhaul, banks are required to hold larger cash cushions against unexpected losses, limit the amount of debt they can hold relative to their own capital, and are forced to maintain a stock of assets that can be sold in a pinch. The measures strengthen the financial system.
Still, Africa’s lenders and policymakers are intensifying calls for tweaks to Basel III, arguing that its uniform application ties up a greater proportion of banks’ funds in reserves, making it costlier and harder to finance long-term projects.
Standard Bank CEO Sim Tshabalala, who chairs the B20 finance and infrastructure task force, and Absa head of sustainable finance Punki Modise argue that the current risk-weighting rules effectively choke off financing for long-dated projects, from roads and railways to power grids and classrooms.
Backed by institutional firepower, including Patrick Njoroge, the former Kenya Central Bank boss, and Ndidi Okonkwo Nwuneli, president of One Campaign, they want infrastructure carved out as its own asset class with lower capital charges, freeing up billions for development.
Mpofu’s research stays agnostic about specific asset class carve-outs, simply measuring how blanket Basel rules have affected non-performing loans across banks. Even so, its core finding that one-size-fits-all capital buffers can backfire underpins the case for a more granular treatment of sectors like infrastructure.
Africa faces an annual infrastructure funding shortfall estimated between $130bn and $170bn, according to the African Development Bank. High borrowing costs, inflated by what critics call an “African perception premium”, leave many governments paying more interest than on health or education spending.
Still, critics have cautioned that diluting capital rules for one sector could set a dangerous precedent. Reserve Bank governor Lesetja Kganyago, the custodian of SA financial stability, has warned that selective relief might invite arbitrage-driven carve-outs for housing, education and other industries, endangering the integrity of the entire capital framework.
Meanwhile, in Washington, the Federal Reserve is preparing to roll back key elements of Basel III “endgame” framework, another sign some regulators are questioning whether post-crisis capital surcharges stifle lending more than they shore up stability.
Mpofu’s paper is also a timely contribution ahead of the B20 task force due to deliver its policy proposals next month.
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