According to a latest research paper by the Reserve Bank Of India which examines the role of regulatory bank capital in influencing credit flows and GDP growth, higher capital tends to lower risk premium and overall cost of liabilities of banks, which in turn helps augment credit growth. Regulatory capital to risk weighted assets ratio (CRAR) is also found to work like a macro-prudential tool as a higher CRAR triggers loan portfolio reallocation in banks away from unsecured high-risk loan towards secured and low risk loans.
Regulatory bank capital shock in the Indian context renders a positive credit-led push to GDP growth by strengthening the balance sheets of banks and the consequent reduction of their overall cost of borrowings. This seems like an idealistic situation as the benefits of mitigating crisis through raised capital comes with the added fillip to GDP growth. This output-enhancing effect of greater capital holding by banks does not defeat viable macro-prudential role of capital adequacy as a leverage tax on risky lending. Under a regulatory capital shock, banks readjust their risky loans and shift towards assets that carry lesser risk weights that ultimately raises aggregate credit flows.
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