Capital Requirement and Risk Behavior Arab African

Capital Requirement and Risk Behavior

Arab African International Bank

Midan ElSaray El Koubra, Garden City Caoro

The research will mainly dwell on the capital requirements and risk behavior of banks, more in particular the credit risk. The purpose of this research is to identify and analyze the relationship between capital requirements and the risk behavior of banks in Egypt

more in particular the Arab African International Bank, which is the case study for this research. Secondly, the research will seek to investigate the impact of capital regulation on the banking behaviors and particularly on the levels of credit risk of banks operating in Egypt

The findings of the research show that there is negative relationship between capital requirement and banks' risk behavior; the findings also show there is empirical evidence to prove that capital regulations have a negative impact on credit risk of banks levels of credit risk of banks operating in Egypt.

Table of content

Chapter 1 Introduction to Research

1.1 Introduction & #8230;.5

1.2 Problem Statement & #8230;6

1.3 Research objectives 7

1.4 Research Questions 7

1.5 Research Hypotheses 7

1.6 Conceptual Framework 8

1.7 Egypt's Banking Sector 10

1.8 Regulations Issued by the CBE 13

Chapter 2 Literature Review

2.1 Introduction & #8230;.14

2.2 Definitions 15

2.3 Credit Creation 15

2.4 Contraction of and Limitation of Credit Creation..

2.5 Objectives of Credit Risk Control 18

2.6 Methods and Instrument of Credit Risk Control 19

2.7 Difference between the quantitative and the qualitative method 20

2.8 Minimum Capital Requirements 21

2.9 Open market operations vs. capital adequacy ratio 22

2.10 Limitations of the capital requirement 24

2.11 Conclusion 25

Chapter 3 Research Methodology

3.1 Introduction 25

3.2 Primary Research 26

3.3 Secondary Research 26 3.4 Research Method 27

3.5 Research Instruments

3.5.1 Questionnaire 28

3.5.2 Interview 28

3.6 Proposed Sampling Method 29

3.7 Data Collection Plan 30

3.8 Data Analysis: quantitative / qualitative analysis 30

3.9 Research Ethical Considerations 31

3.10 Research Limitations 31

3.11 Conclusion 32

Chapter 4 Research and Findings

4.1 Financial Highlights & #8230;.32

4.2 AAIB Loans 35

4.3 Capital Adequacy 35

4.4 Assessment of capital ratio and credit risk 36

4.5 Relation between capital requirement and credit risk 36

4.6 Impact of capital requirement on risk behavior of AAIB and other Egypt's Bank 38

4.7 Observations of variables, which affect changes in bank's capital and risk

4.7.1Regulatory pressure 41

4.7.2 Banks absolute capital buffer 41

4.7.3 The bank size 41

4.7.4 Risk of greatly loan loss 42

4.7.5 Risk of bank run 42

4.7.6 Weights of the claims on the state 42

4.7.7 Current profit 43

4.7.8 Regulatory shocks and macroeconomic shocks 43

Chapter 5 Conclusion and Recommendation

5.1 Conclusion 43

5.2 Recommendations 44

Bibliography 46

Appendix

a) Questionnaire 52

b) Introductory letter 53

c) Regression analysis & #8230;54

d) Market share of AAIB 55

Abstract

The research will mainly dwell on the capital requirements and risk behavior of banks, more in particular the credit risk. The purpose of this research is to identify and analyze the relationship between capital requirements and the risk behavior of banks in Egypt more in particular the Arab African International Bank, which is the case study for this research. Secondly, the research will seek to investigate the impact of capital regulation on the banking behaviors and particularly on the levels of credit risk of banks operating in Egypt.

The findings of the research show that there is negative relationship between capital requirement and banks' risk behavior; the findings also show there is empirical evidence to prove that capital regulations have a negative impact on credit risk of banks.

Chapter 1

Introduction to Research

1.1 Introduction

Over the past years, capital adequacies of banks have gained a lot of attention due to the need for financial stability in the entire financial system both at the national and international level. The first inaugural call in this direction was in 1988 when a group of ten countries known as the G-10 signed into agreement the minimal risk-based capital for banks. This agreement was later to be known as the Basel accord. In the recent years the Basel committees has implemented a number of reforms in the Basel accord in order to be in line with the current financial system.

The issue of capital adequacy is raised when the discussions of financial risk are being debated. Financial institutions are prone to or are exposed to risks such as credit risk, liquidity risk, interest rate risk and capital risk, and as such are the need for precautionary measures to be taken to prevent such risks from occurring. Perhaps to understand the multitude of financial risks not only to the local economy but also to the international economy, scenarios such as the 1930's great depression, the recent credit crunch and the subsequent recession that followed or even the case of Greece financial crisis.

This research is commissioned to identify and analyze the relationship between Capital requirements and the risk behavior; secondly, it is supposed to investigate the impact of the capital regulation on the banking behaviors and particularly on the level of credit risk, they undertake.

This paper will first introduce the topic of research, the problem statement and then it will highlight on some of the research objectives and questions, before spelling out the conceptual framework of this research. The second chapter will look at the literature on capital requirement and credit, more in particular about the credit creation and risk control. The third chapter will be for the research carried out on the case study of Arab African International Bank as an international bank operating in Egypt, thus the reason why this paper will solely focus on Egypt. In this third chapter, the research will try to assess the Arab African International Bank capital ratio and credit risk to build on the research findings in the fourth chapter. The fourth chapter will point out the research findings on the issues that were to be investigated by the research. Lastly, the paper will conclude with a few recommendations pertaining to the research topic.

1.2 Problem Statement

At the inception of the Basel I accord few countries were hesitant to implement the guidelines as mentioned by the accord, more in particular was Egypt. Before the 1990's Egypt, financial system was reported to be in a havoc situation as there banking institution was merely left to govern itself keeping in mind it was dominated by state-owned banks. This financial environment meant that Egypt's banking system was less developed and the economic growth of the country was largely hampered by this. There was almost no competition in the banking sector as most banks were state-owned and hence their income was guaranteed, the private sector more in particular the small and medium investments were largely un-catered for by the public banks, about only 10% of the entire population had previously or currently owned bank accounts and on the other hand the banks themselves were recording high numbers of non-performing loans an indication that the banking system in Egypt was in a problematic condition.

Reforms started in 1993 with the privation of most state-owned banks and again in 2003 after the appointment of Dr. Farouk El Okda as the new central bank governor, followed also by appointment of a new cabinet including also a new prime minister called Ahmed Nazef in 2004, major reforms were implemented in Egypt's banking sector. The reforms saw Egypt adopt the Basel I guidelines and even introduced the concept of minimum capital requirement to safeguard against credit risks in banks.

1.3 Research Objectives

The research aims to identify and analyze the relationship between Capital Requirements and the risk behavior: Arab African International Bank (AAIB) case study.

The research also aims at investigating the impact of the capital regulation on the banking behaviors and particularly on the level of credit risk of Banks operating in Egypt.

1.4 Research Questions

Does the regulatory pressure imposed by minimum capital requirements efficient in reducing risk behavior of (AAIB)?

Does a capital requirement influence the risk behavior of AAIB?

Is there a correlation between the change in capital adequacy ratio and credit risk ratio?

1.5 Research Hypotheses

Hypothesis 0: there is no relationship between capital requirements and banks' risk behavior.

Hypothesis 1: there is a negative relationship between capital requirements and banks' risk behavior.

1.6 Conceptual framework

Capital requirement is necessitated by capital regulations and it comes in the wake of bank default. Capital regulations are established to safeguard against bank default which has very serious repercussions not only to the shareholders and depositors but also to the general banking industry and the entire economy of a country. Bank defaults result to financial loss for its' shareholders and depositors or customers, while for the banking industry itself it will loss on competitiveness that was in the industry and the general economy will be destabilized by the banking crisis, since the banking industry plays a key role in a stable economy. It is due to these reasons the central banks of each and every country is obligated to set banking regulations that will cushion shareholders, banks' clients and the general economy from bankers' risk taking potential that can result to a bank default.

The repercussion of bank failure has captured the attention of many industry participants. When relating to experiences such as the 1930's great depression, the recent credit crunch and the subsequent financial crisis in the period of 2007-2010, it is evident as to what are the dangers of a bank default to the global banking system. The similarity in all of the three mentioned financial crisis was the causes and the side effects, apparently poor banking regulations and laxity in the regulations which were in place contributed to the financial mess, as for the consequences they were all similar as many banks and mostly the smaller banks had to close shop, while others were offered stimulus package to prevent them from collapsing.

Such scenarios that not only affected the banking system of one country but the entire world wide banking system necessitated the call for a standard global banking regulations. The Bank for international settlement (BIS) was formed as an answer to these calls. The bank for international settlement established a committee known as the Basel Committee which in its' mandate proposed an accord on bank capital minimum levels which was known as the Basel I accord. The Basel I accord aimed at encouraging and attaining an internationally accepted standard minimum capital requirements. By using the Cooke Ratio, it aimed formulating a regulatory requirement based on banks' capital. To attain its objective the Basel I accord raised the capital ratios and encouraged banks to approach credit risk from a different perspective, in that the banks' portfolio risk should be subjective to the bank's capital requirements.

Credit risk is the primary focus of the Basel I accord and it defines it as the risk of loss that is brought about by default of counterparty or a borrower. The accord requires that banks should always meet the established two ratios for capital adequacy that are total capital ratios and tier 1 ratio. Both of the two ratios have similar denominators, which is the risk-weighted sum of the bank on and off balance sheet activities. The numerator for Tier 1 ratio is the bank's core capital that is disclosed reserve plus the shareholders equity capital. As for the total capital ratio the numerator is both Tier 1 and Tier 2 of which Tier 2 capital includes subordinated debt and undisclosed reserves.

The Basel I accord recommends that banks should have at least a capital ratio of 8% which has however being reviewed and a credit risk of 4%. It is important to note that in the capital ratio requirement Tier 2 (also called supplementary capital) contribution should not exceed 50% from Tier 1 (also called core capital). Bankers and economist are of the opinion that banks which wish to meet these Basel I accord requirement should adjust their balance sheet in such a manner so as to raise the capital level, reduce the risk weighted bank assets in proportion to the bank's total assets or reduce its' total assets entirely.

Boot and Thakor (1993, 420-437) and De Carmoy (1990, 45) have faulted the capital regulatory standards such as the international Basel I accord on its aforesaid impact on the banks portfolio risk. The authors suggest that by using a mean-variance framework, it is apparent that an increase in capital requirement standards may have an opposite impact than the one intended as bankers are likely to increase their bank's portfolio risk. When using the dynamic framework Calem and Rob (1996, 36) also concluded that by pressuring under capitalized banks to meet the set capital requirements, it has the likely impact of forcing them to increase their bank's portfolio risk in one period so as to meet the requirements in the subsequent period that follows.

On another study conducted by Enoch, Stella and Khamis (1997, 97-138) which considered the incentives of the manager, shareholder and the deposit insurer in relation to a banks' capital level and the risk taking behavior. Enoch, Stella and Khamis concluded that three mentioned participants have big influence in terms of the level of risk in relations to the capitalization level.

1.7 Egypt's banking sector

According to the World Bank economic guidelines; a country's economic success can be propelled only by a banking system that is well established, profitable and trustworthy. Thou Egypt have experienced a commendable economic growth for the past few years, reports indicate its banking system can't take any credit for it because it is marred with problems associated with non-performing loans, weak supervision and dominant, non-competitive, unprofitable and inefficient public banks. However it is important to note that there is no empirical evidence to substantiate these problems as claimed by the report. But problems such as the non-profitability of public banks mainly attributed to high number of loan loss provisions and low income can be substantiated. Another problem that can be substantiated is related to Egypt's bank structure of the balance sheet which indicates that risk avoidance to be the main approach in credit risk management.

Bhattacharya, Boot and Thakor (1998, 745-770) in their studies lamented that the Egyptian banking industry took a longer than usual time to develop a remark justified by the survey which was conducted by the Business Monitor International group in 2006 which showed at that time only 10% of the entire Egypt's population had owned or owned bank account. This figure is contrary lower to what other countries had even the emerging economies. The public banking institutions that have ever since dominated Egypt's banking sector is another problem that has impaired the growth of the country's banking industry and the economy as a whole.

Since such banks strongly rely on the guaranteed government income and their investment in government's treasury bills and bonds which have a short maturity period coupled with a guaranteed income plus low returns, they had being reluctant to serve the small and medium customers, whom are in dire need of banking services plus they have the potential to develop the economy as much as large clientele can. Furthermore the other factor that contributes to Egypt's poor development in the banking industry is the rate of non-performing loans which is stimulated by poor legal framework that causes collaterals taken on loan to be uncertain guarantee.

Calomiris and Powell (2000, 77-98) noted in their studies that the weak supervision of Egypt's banking sector by the country's central bank is largely to blame for the high number of non-performing loan that has been recorded in the country history, for example according to reports released by the Economist Intelligent unit and the Business Monitor International group in 2006 all showed that total number of bank's bad debts were estimated to constitute at least 20% of the total loan portfolio by 2006. Corruption in the bank lending process that has being facilitated by weak supervision by the central bank has also lead to the high number of non-performing loans. Without regard to future cash flow of the customer, banks blatantly overvalue the assets they bring in as collateral and give such customers loans that end up becoming non-performing loans. On the other hand state owned banks lend public sector companies as a direct order from the government without following the due process of lending; such a case was in 2004 when reportedly four public banks were owed more than thirty billion won by state-owned companies.

Referring to studies conducted by Dobronogov and Iqbal (2005, 42), they attributes the banking reforms in Egypt which were initiated in 2004 to the appointment of a new central bank governor in 2003 and the subsequent appointment of a new cabinet and a prime minister in 2004. For the first time in 2004, the government started taking drastic measures towards both private and public banks which were faced with increasing rate of non-performing loans. Later on other reforms were taken that include acts such as privatization of public banks, restructuring of the entire banking system, revaluation of the capital requirements and the strengthening of banking supervision.

Hellmann, Murdock and Stiglitz (2000,147-165) elaborate on this reform by saying that "the first reform was to raise the capital requirement for banks operating in Egypt" in doing this the central bank of Egypt together with the government formulated a new banking law that is known as 'law no.88/2003' which was effected in July of 2003. Law No. 88/2003 stipulated that the new minimum capital requirement for local banks will be EGP 500 million while that for foreign banks with branches in Egypt will be 50 million U.S. dollars. Moreover the law also required that bank abide by the set 10% risk-weighted capital adequacy ratio. These strict conditions set by the law resulted to mergers and acquisitions between banks as they tried to beat the deadline for the minimum requirement.

The second reform to follow was the restructuring of state owned banks in terms of their administrative and financial structures. The third reform was the privation of government -- owned banks and diversification of their stakes in joint ventures with foreign players. The privatization program was reportedly a five-year plan that was stipulated to begin in 1993 and close in 1998 and according to the central bank of Egypt 13 out of 17 public banks were privatized by the end of 2006.

The fourth reforms was stiffening banking supervision by the central bank and it is important to note that in doing so the central bank of Egypt complied with almost all of the Basel Accord guidelines for effective banking supervisions. In order to effectively supervise banks portfolio risk, the central bank adopted a supervisory method that was based on evaluation of risk and assessment of the bank's abilities to identify current and future risk. To tackle the issue of non-performing loan the central bank established a sub-unit called non-performing loans monitoring unit that was mandated to update loan defaulters register and aid in collecting repayments for loans advanced by commercial banks.

1.8 Regulations issued by the CBE

All banks registered with the central bank of Egypt, additionally branches of foreign banks must also comply with C.B.E regulations concerning maintaining a certain ratio between their capital base and their risk weighted assets to meet credit risk (as per Basel I capital accord) to protect depositors' interest.

A capital requirement of 10% of each bank's total risk weighted assets must be kept to meet credit risk. The capital base equals to the sum of Tier 1 and Tier 2, where Tier 1 or core capital consists of: paid-up capital, reserve and retained earnings. Tier 2 or supplementary capital which should not exceed 50% of the core capital, consists of: general provision for performing debts which should not be more than 1.25% of all risk weighted assets, subordinated debts, asset re-valuation reserves which is 45% of the difference between the securities fair market value and book value. More over all banks operating in the country are required to submit a quarterly report showing their capital adequacy ratio.

Chapter 2

Literature review

2.1 Introduction

This chapter has largely dwelt on the topic of bank's credit and capital requirements. Other methods or instruments that are used in controlling credit creation as well as credit risk will also be briefly discussed.

This chapter aims at giving the reader a more thorough insight on capital requirement and bank's credit and thus it prepares the reader in easily understanding the research and its findings.

2.2 Definitions

Greene (2000 45-56) defines capital risk as the ratio of capital to risk-weighted assets or the ratio of capital to total assets. Haber (1991, 559-580) defines credit risk as the ratio of risk-weighted assets to total assets, this rationale reflects on banks' decision on risk-taking with appropriate timelines.

2.3 Credit creation

When looking at the issue of capital requirement and risk behavior, what comes first in mind is the issue of credit creation because capital requirement have an influence on credit creation and the amount of credit risk is affected by the amount of credit created or vice versa.

According to Jacques and Nigro (1997, 49) credit may be defined as the right to receive payment or the obligation to make payments on demand or at some future time on account of immediate transfer of the sum borrowed. The one provide credit is known as the creditor or Lender and the subsequent recipient of the credit is known as the debtor or borrower. Credit amount is the liability of the debtor and is the asset to the creditor. Banks can create credit from a fractional reserve system where a part of their customer deposit is deposited in the country's central bank, thus banks are regarded as the manufactures of credit. Credit creation refers to the power of banks to create demand deposits through loans, advances and investments. With an initially smaller amount of money in the beginning, banks can create a large volume of additional purchasing power in the economy. Credit creation implies the creation of additional purchasing power and it also implies the multiplication of demand deposit.

Koehn and Santomero (1980, 1235-1244) noted that the liabilities of banks can be used as a medium of exchange in the market for exchanging goods and services. The deposit of the people held with the commercial banks can be regarded as the basic input for the creation of credit or demand deposit. The demand deposits are created when a bank gives loan or advances to its customers, in such circumstances banks create claim against themselves and in this process, credit is created. Credit creation can be regarded as the monetization of assets.

This overview is important as it helps us to know how and where the central bank applies its regulations in order to control credit risk, and it starts right from the point of credit creation by commercial banks.

2.4 Contraction of and limitation of credit creation

First when a bank is fully loaned up i.e. excess reserve is zero, a loss of reserve will lead to contraction of deposit. Secondly, cash leakage lowers the power of credit creation of the banking system. The drain of cash into the circulation outside the banking system is the decisive factor limiting the power of the bank to create credit. The bank cannot extend the loans beyond the limits of safety. It should maintain adequate cash reserve to meet its obligation.

Thirdly, monetary policy is an important factor determining the capacity of credit creation. The total reserves of banks depend on the policy of the central bank and the central bank by manipulating the credit instruments can influence the creation of credit via the reserves of the bank.

Fourthly, amount of idle reserve is also a determinant of credit creation. The larger the amount of idle reserve the lower is the power to create credit because money is blocked. Banks always maintain this idle reserve. The extent of idle reserve of the banking system depends on the nature of money market of a particular country. In a country with developed money system, the banking system need not maintain idle reserve since the excess reserve over and above the minimum requirement is fully utilized.

Fifthly, credit creation also depends on the demand for credit and the availability of securities. Banks create credit against approved securities. Non-availability of good securities as well as good borrowers imposes limits on the power of the bank to create credit.

Sixthly, bank's power to create credit is limited by the amount of cash the customers are willing to keep in the banks. When the primary deposit is low, deposit creation is also low. Similarly, when people keep more money with banks, larger deposit liabilities can be created by the commercial banks.

Based on this research credit creation also depends on the minimum legal requirement. If the value of capital requirement is small, credit creation becomes large. Similarly, if the value of minimum requirement is high, the amount of deposit creation becomes low. Oldham and Benaddi (2005, 56) noted that the value of capital ratio depends on the monetary policy of the central bank of Egypt and the value of capital ratio is raised during the period of inflation and the value of capital ratio is lowered during the period of depression.

Banking habits of the population also matter in credit creation, if people prefer cheque then credit creation becomes limited also if the population has confidence in the banking system, the banks can create sufficient credit.

Credit creation or the amount of credit risk depends partly on the rate of interest. If the prevailing rate of interest in the market is low for borrowing and lending, a bank does not consider the creation of credit or the amount of credit risk to be profitable. On the other hand when the rate of interest is high credit creation becomes a profitable business which a commercial banks purse with interest.

Credit creation is the function of investments and economic climate of a country. If the investment market is dull and the economic climate is uncertainty, risky and unstable credit creation becomes highly limited. Credit creation is encouraged during boom and buoyancy.

Lastly, credit creation is limited by the whole banking system since banking discipline is very essential. One bank cannot expend when other banks are contracting credit creation. Credit creation is a joint action based on discipline and coordination. It depends on the efficiency of the whole banking system.

2.5 Objectives of Credit Risk Control

Referring to the studies done by Polizatto (1992,78) some of the most important objectives for credit risk control include; obtaining stability in the internal price level, by adjusting the demand for and supply of credit with reference to the output of the economy. Another objective of credit risk control is the attainment of stability in the exchange rate, as it is well-known; instability in the rate of exchange can have harmful effects on the foreign trade of a country. Thus, the credit risk control policy should aim at eliminating the violent fluctuations in the foreign exchange rates.

The aim of credit risk control is to bring about stability in the money market of a country. This can be done by neutralizing the seasonal variations in the demand for credit. For example if there is excess supply of funds in the money market, that can be wiped out by controlling the credit creation. The other aim of credit risk control is to eliminate the business cycle of inflation and depression by controlling the supply of credit in the economy.

According to Rime (2000, 789-805) credit risk control is done in such a way that it can maximize income, employment and output in a country. This can be done by properly utilizing the existing credit and also by creating additional credit risk, if necessary. Credit risk control also aims at meeting the financial requirement of an economy not only during normal times but also during an emergency or war.

All authors and financial consultants are in consensus that the most important objective of credit risk control policy is to help the economic growth of a country within the specified period duration. This objective has become particularly necessary for the less developed or developing countries in the present world.

2.6 Methods and instruments of credit risk control

Credit is the life-blood of modern exchange economy. However, the greatest advantage from credit is attained if it is properly regulated and controlled. If credit is not properly controlled, it may create havoc in the national economy. It is the duty of the central bank of Egypt to ensure that only the proper amount of credit is created, but it is also controlled in a proper manner that the optimum advantage can be derived from it.

There are many methods of credit risk control, but methods Reilly and Brown (2006, 45-67) classified them into two broad categories that include; quantitative or general methods and qualitative or selective methods. The quantitative method of credit risk control aim at influencing the quantity or the volume of credit in an economy during a particular duration. The qualitative method of credit risk control aims at influencing the quality of use of credit with respect to a particular type of activity and it may be denied to another type of activity. The main objective is to regulate the use of credit in the selected fields only. For instance, in a growing economy, additional credit can be granted for the development of the productive and core sector, and it may be denied to the unproductive and speculative sector.

Under the quantitative system of credit risk control, the following instruments are used: bank rate, open market operation and minimum capital requirements.

Under the qualitative system of credit risk control, the following instruments are generally used; margin requirements, regulation of consumer's credit, direct control and moral persuasion among others.

2.7 Difference between the quantitative and the qualitative method

The general or the quantitative method of credit risk control is focused mainly to affect the lenders, but the qualitative method of credit risk control affects both the lender and the borrowers. Not every kind of borrowers' activities can avail of the selective type of credit. Similarly, lenders are also free to advance money in all types of lending activities.

The quantitative method of credit control is very general in nature, but the qualitative methods are more direct and particular. The quantitative method work under given conditions in the credit market. The qualitative method can change the conditions and circumstances. The selective methods are more discretionary and compulsory. The quantitative methods on the other hand do not have any element of compulsion discretion.

The quantitative methods of credit control are somewhat impersonal in nature. The central bank does not directly participate in the management of such credit, but it only watches the development after this type of credit control method is used. On the other hand, the use of the selective method of credit control is highly responsible for both the central bank as well as for the commercial banks. The central bank has to supervise the working of the qualitative method of credit control.

The quantitative methods of credit control intend to influence the total quantity and the volume of credit, but the qualitative methods regulate the flow credit in the strategic sectors of the economy. The selective method is not concerned with individual use of credit with respect to different types of activities. The selective methods are essentially very choosy, discriminatory and selective in the manner in which credit is granted.

2.8 Minimum capital requirements

This a comparatively new method introduced by the Basel committee in the 1980's, it is a method of credit risk control that's applied by the central banks of organized money market: note Egypt had to structure its banking system with couple of reforms before it could apply this method of credit risk control. Commercial banks, in for instance Egypt keep cash reserve with the central bank. This reserve is maintained for the purpose of liquidity and also providing the means for credit risk control. The cash reserve to be maintained with the central bank of Egypt is termed as the minimum legal reserve requirement. This is done on the basis of central bank rules and regulations. The minimum reserve ratio is a percentage and as for Egypt it is 10%, which is consistent with the Basel I accord; however under the Egypt banking law the central bank of Egypt has the powers to legally change this ratio. Thus, the reserve is variable. Law No. 88/2003 stipulated that the new minimum capital requirement for local banks in Egypt shall be EGP 500 million while that for foreign banks with branches in Egypt will be 50 million U.S. dollars. Moreover, the law also required that bank abide by the set 10% risk-weighted capital adequacy ratio.

In this connection, it is important to note that the credit risk undertaken by the banks depends on the value of the minimum legal reserve requirement; this is from a theoretical perspective. This implies that as the amount of minimum requirement increases the credit risk undertaken by banks decreases. Likewise, if the value of minimum requirement decreases the credit risk undertaken by the commercial banks in Egypt such as Arab African International Bank increases. It is important to note that when credit expansion is needed the minimum capital requirement is reduced and when the credit is to be reduced the capital ratio is raised. Thus by adjusting or varying the capital ratio, the lending potential of banks can also be changed.

This method of credit risk control affects the volume of cash reserves with the commercial banks and therefore it affects the credit creation multiplier of commercial banks. The minimum requirement is increased during the period of inflation to reduce the credit risk of commercial banks and it is reduced during the period of depression so that commercials banks operating in Egypt can create more credit for the economy.

2.9 Open market operations vs. capital adequacy ratio

Van Horne and Wachowicz (2005, 56), in their studies elaborate some of the difference between the open market operations method and capital ratio method or instrument of credit and liquidity risk control which include; open market operations method is undertaken by the government through the central bank of the country which purchases securities from the open market both short-term and long-term. This method reportedly became very popular after the First World War and it was used to save banks in situations where there were threatened with risks such as liquidity risk. The central bank would purchase securities from the open market; this gives enough money in the hands of the banks save situations like the run on the bank.

In comparison the capital ratios is more direct and prompt method of credit risk control. It can achieve the desired results almost immediately; hence, it reduces the time lag while the open market operation involves time lag and delay.

Secondly, the open market operations cannot be practiced in a narrow security market, but the minimum capital requirement has no such limitation. Thirdly, for open market operations in the case of large-scale transaction may result to a loss to the government as well as the central bank. The capital ratio may get the same result but without fear of loss.

Fourthly, the capital requirement affects all banks while the open market operations method affects only those whom deal in securities.

However according to Sheldon (1996b, 709-734) an economist, the capital requirement has not yet fully developed as a sensitive and delicate credit control instrument. The changes in capital requirement involve a larger amount of money than the open market operations method.

The capital minimum requirement is viewed by many to be clumsy, discriminatory and inflexible type of credit weapon but the open market operations is flexible, delicate and neat. Talley and Mas (1992, 112-123) noted that with the growth of non-bank financial intermediaries the efficacy of open market operations has increased further relative to capital requirement. The non-bank financial intermediaries invest in large quantities of government securities, but they do not maintain any legal reserve. Thus whereas a change in capital ratio cannot influence the risk behavior of non-bank financial intermediaries, the open market operations can.

The open market operations can affect both the structure of the interest rate as also the bank reserve, whereas the capital ratio can only affect bank reserve and not directly the structure of interest rate.

2.10 Limitations of the capital requirement

According to Rochet (1992, 1137-1178) the capital requirement is a discriminatory type of credit risk control, larger banks are not affected much by the capital ratio but the small banks are hard hit. It produces shocks to the commercial banks and breeds uncertainty. When the capital requirement is increased, the common banks incur losses. The common banks may increase deposit reserves by selling securities, therefore the security market will be depressed and to avoid such a scenario simultaneous market purchase is required.

When commercial banks have excess reserve, the capital requirement is not effective. The lending policy of a bank is not really determined by the capital requirement but it is determined by many other factors that include the banks shareholders and the business environment.

The exact effect of capital requirement depends on the actual demand for credit from all the sectors of the economy. If the demand for credit from the economy does not change to a particular manner or a manner that was forecasted by financial analyst, the capital requirement may as well be ineffective. In addition, the frequent changes or alteration by the central bank of countries on the capital requirement level is disturbing. This method can thus be used only when a large change in credit is required.

This method is not suitable for making local adjustments in credit situations and if the capital requirement is raised, the earning capacity of the commercial banks is reduced.

2.11 Conclusion

This chapter largely dwells on credit risk and how different methods can be used to control credit risk or in other words credit creation. Two relevant methods have being mentioned that is the qualitative and the quantitative method, but it is apparent that the quantitative method which includes capital requirement is the most effective.

Important to note is that there is a negative relationship between capital requirement and credit risk and apparently the capital regulations have an impact on the risk behavior of banks. Risk behavior of banks is influenced by other factors such as shareholder incentives and the general business environment.

Chapter 3

Research methodology

3.1 Introduction

This chapter spells out the procedures and the methods that the researcher will employ in achieving the objectives of the research as highlighted in the abstract of this paper. It defines location of the study, research procedures and analysis plan that would be put in consideration when carrying out this particular research. The research is supposed to start with the clear understanding of the research objectives as well as the hypothesis. Success of the project will depend on the provision of satisfying information in line with the objectives and hypothesis.

The objective of the research just as a recap is to identify and analyze the relationship between Capital Requirements and the risk behavior of Arab African International Bank (AAIB) case study, the other objective is to investigate the impact of the capital regulation on the banking behaviors and particularly on the levels of risk. It is important to note here that this research was mainly based on the case study even though other research methodologies were briefly discussed.

3.2 Primary research

Primary research is the collection of data that does not exist. This can be through numerous forms: including questionnaires, telephone conversations, surveys, etc. As pertained to this project, the primary sources would likely be the Arab African International Bank. The major merit with conducting primary research is that it accurate. However, the disadvantage of primary research is that it may be time consuming, as it involves dealing with people from various sectors of the Egyptian banking system, the human sources may only become resourceful out of their own willingness, and this may take them quit sometimes before making up their minds to tell you what they know or give you their side stories about your questions.

3.3 Secondary research

Secondary research on the other hand is the collection of existing data, that is, in contrast to primary research. The merit of secondary research is that it is not time consuming however; a disadvantage is that the information retrieved may not be relevant.

Note that the primary research will be used to verify the findings of the secondary research.

3.4 Research methods

Another aspect that is of great significance in this research would be the research strategy. It is the research strategy shows which methods a researcher adapts to answer the research objectives or questions. There are types of research strategies that can be employed in conducting a research study. These include experiments, case studies, survey, theoretical perspectives, cross-sectional and longitudinal studies. It is imperative to examine the case study method and the survey method that will be applied in this particular research.

Survey is an important research strategy that was popular in conducting this research. Surveys allow the collection of a large amount of data from a large population .This implies that the researcher can conduct surveys and questions to specific groups of people to obtain large amount of information relevant to the subject of the survey. The data is usually collected from the people either via questionnaire or orally. The purpose of the survey was to establish and analyze views of respondents in order to find what they think about particular situation, case or statement. However, despite the fact that the views from a large number of respondents can be gathered through the survey strategy, the data obtained might not reflect the objective of the research at an in-depth level.

Case study is a research strategy which involves investigation of a particular contemporary phenomenon in the real life situation using multiple sources of evidence like financial statements. More elaborate explanation on the nature of the case study as a research strategy was given by Van Horne and Wachowicz (2005, 56) who view case study as a representation of 'a specific way of collecting, organizing, and analyzing data'. Grounded theory represents a strategy which posits that the data is collected through observations and compared to various theoretical frameworks in order to discover which of the data is the most appropriate. This leads the researcher into making predictions about the studied phenomena prior to putting the findings into test. However, the aim of grounded theory is to make studied data records well developed and understood and to verify relationships between the findings and the case study.

3.5 Research instruments

3.5.1 Questionnaires

The questionnaire enabled the information to be gathered from many respondents who were directly involved in the banking industry with specific cases of Arab African International Bank. Use of a questionnaire as a quantitative method for collecting data from the sources is the most appropriate method of collecting mass responses and as such, providing a good method of comparative analysis. The questionnaire will cover a number of data sources to find out opinions and views regarding the implications of capital requirements on risk behaviour of AAIB. Designing good questionnaires requires significant skills and experience. The researcher embarks on the study by setting up survey questionnaires that address issues relevant to the interviews conducted, an example of survey questionnaire that is used in the research is shown in the appendix.

3.5.2 Interviews

In order to achieve the purpose of the investigation, the key focus lies on finding out which techniques should be applied. Interviews were among the best method for understanding this research. "A respondent interview is one where the interviewer directs the interview and the interviewer responds to the questions of the researcher." Greene (2000, 56) also elaborates by describing interviews as the verbal exchange of information between two or more people for the principal purpose of one person or group gathering information from the other.

In order to analyze the psychological and behavioral reasons for decisions of the sources, the collected primary data should be collected through the distribution of questionnaires. Greene however emphasized it is very important to note that questionnaires should reach the right people, to allow for an appropriate amount of information to be collected.

3.6 Proposed Sampling Method

The sampling method of choice in this case is simple random that considers a specific size. All the subsets in the sample have an opportunity of being given an equal chance of participation. This therefore implies that every one element in the frame is given equal probability in participation. There is no subdivision or partitioning of the frame. Pairs and also triples if they exist are also accorded equal opportunities. This leads to the minimization of bias in addition to the simplification of the result analysis process. The variance that may exist between results on an individual capacity in the context of the sample forms can be the best indicator of the variance in the entire population. This therefore also leads to the simplicity in the estimation of the accuracy that the results may have.

There is however a high possibility of vulnerability to sampling errors in the use of this Sampling method. This is attributed to the randomness in the process of selection that may lead to a sample that may not reflect the actual make up that is evident in the population. There is also an aspect of cumbersome that is associated with this sampling method as it might also be tedious if sampling is intended at populations that are unusually large.

3.7 Data collection plan

Use of research tools such as questionnaires, interviews, relevant journals, periodicals, financial statements and data sampling and machines would be utilized in the process conducting the interview.

In implementing the activities, both the quantitative and qualitative approaches was considered, where by qualitative data are those that would be based on the spoken words while the quantitative data would be generated from the overall data collected based of accuracy and efficiency The research project was scheduled to run for a reasonable duration of time within which the Arab African International Bank and its financial statements would be put under scrutiny and rigorous investigations to ascertain the objectives of the research.

3.8 Data Analysis: quantitative / qualitative analysis

There are two main ways in implementing the activity of analysing the data that has been obtained in a research, quantitative approach and qualitative approach. The Qualitative data analysis is the analysis of data which is based on meanings spoken through words or personal expressions from the respondents. Qualitative analysis of data is one of the major methods for data compilation and interpersonal interviews.

Quantitative analysis of data is a process that is based on the amount of data collected from the identified materials (sources such as financial statements of AAIB) such information are often accurate and not prone to human manipulations.

3.9 Research Ethical consideration

All the participants were given their respectively informed consent for the purpose of participation in the research. They were informed prior to the research, the purposes, the potential benefits as well as the risks that might be associated with their participation. Ethical standards shall be considered in the process of the procedures of the research.

It is an ethical requirement that all the people taking part in this study shall be informed about the rationale of the research and the intentions of the researcher by means of a letter of introduction that shall be sent to them. All the findings taken care of higher levels of confidentiality and as a matter of ethics, none of the sources, be it personal or at organization level, shall correlated with any particular observation, nor shall any comment be associated without explicit permission from the source. All the information gathered during the interviews shall be treated as confidential and every individual participant shall be given full rights of anonymity. All interviewees shall be treated with high degree of respect and esteem.

3.10 Research Limitations

During the carrying out of the research several challenges were encountered which included:

Some respondents were not willing to cooperate in the process of carrying out of the interview.

Some questionnaires were not properly answered while others remained blank forcing the possibility of assumptions to be included here.

There also existed the tedious and long procedures to be followed in order to obtain the entrance to the AAIB premise

3.11 Conclusion

The methodology which was exploited here mainly through the case study, questionnaires and the interviews were most appropriate as they enabled the most information to be obtained. Many respondents could be reached within a short period of time while sampling enabled a comparison to be carried out on different opinion of participants on the research question. They helped in the real understanding the relationship between capital regulations and risk behavior of banks.

Chapter 4

Research and findings

4.1 Financial highlights

Financial reports of Arab African International Bank

(All amounts in USD Millions)

2009

2008

2007

Total assets

Net loans

Total deposits

Total capital

Gross income

Net income

Percent

2009

2008

2007

NPL/Gross loans

3.42

2.42

3.00

LLR/NPL

97.14

87.76

90.10

Capital adequacy ratio

18.34

14.83

13.43

Net loans/Stable funds

54.96

68.86

38.74

Interest differential

2.61

3.36

2.98

Cost/Income

26.29

27.78

28.97

ROAA

1.8

1.91

1.96

Source: www.aaib.com/financials .com

From the above financial highlights of AAIB it is evident that the bank experienced an improved capital adequacy in all the three periods coupled with good return on equity given use of Tier 2 capital funds. However, assets quality was impacted by the increase in the bank's non-performing loans, as well as by headline watch list loans, on the other hand borrower concentration heightens credit risk, although it is important to note that the bank has been able to maintain the credit risk at a lower level.

The findings of the research carried out earlier showed that there have been some few amendments in the banking sector regulations which affect different areas that include: loan classification and provisioning in which the CBE regulation now requires banks to apply a general provision on all performing loans which ranges between 1% and 5% depending on the obligator risk rating ( ORR ) of the borrower, and since 1st January, last year banks were required to make provisions based on actual losses. Any excess of expected losses over actual losses will be taken as appropriation of profit to the general banking risk reserve.

On the special provisions for retail loans; consumer or mortgage finance should be categorized into three groups which comprise of performing loans, substandard loans, doubtful loans and loss. Performing loans carry a 3% general provision for credit card and personal loans and also 1% for mortgage loans, while specific provisions for non-performing loans start at thirty days past the date that loans are due.

The findings also noted that banks operating in Egypt are required by law to obtain information on borrowers and SMEs from the Egyptian credit bureau before evaluating their credit worthiness. The central bank of Egypt credit bureau has information for borrowers with a debt of more than EGP 30,000, while a private sector credit bureau has information for borrowers with debts lower than EGP 30,000. Another important amendment to note is that as of December 2008, banks were given incentives in the form of exemption from the 10% reserve requirement on deposits for the amount of SME loans granted.

4.2 AAIB loans

A thorough look at the bank's loan asset concentration revealed that the loan portfolio is quite diversified by industrial sector while the loans to private persons represent only a small percentage of the bank's loan. The bank has minimal credit exposure and borrower concentration has shown to improve over the past recent years since the bank has tried to manage and mitigate their credit risk. Lending is still mostly done in short-term tenor, but maturities are lengthened.

The interview with AAIB management revealed that the bank has a long standing credit culture and sound risk management. This has been enhanced by well trained credit officers who use in-house rating system for corporate lending. Credit ratings and proposal on the other hand are independently reviewed by the risk department before they are presented to a credit committee. AAIB has traditionally followed prudent risk management policies and stringent control of credit sanctioning and provisioning, until recently the bank had some of the strongest assets quality ratio within the Egyptian banking industry. However for business reasons the bank had followed a very aggressive credit expansion in the three years period.

4.3 Capital adequacy

There has been a significant increase in capitalization which can be attributed to strong rate of internal capital generation as well as shareholder support. At the end of 2009, the bank was well capitalized with a strong total capital and total risk weighted asset this ratio had more than doubled as result of a USD 300 million subordinated shareholder deposit, resulting in a capital growth rate of 112.6%.

4.4 Assessment of capital ratio and credit risk

From the financial reports so highlighted above it evident that AAIB has managed to maintain their credit risk below four percent as stated by the central bank of Egypt's credit risk requirement. Concerning the minimum capital requirement, it is apparently clear that the bank has been able to maintain an impressive figure for the past three years of capital ratio which are above the 10% mark prescribed by the central bank of Egypt. The research can conclude that there is negative relationship between capital ratio and credit risk because as capital increases the bank's credit risk decreases.

4.5 Relation between capital requirement and credit risk

According to the research carried out and also studies carried out by authors such as Hellmann, Murdock and Stiglitz (2000, 147-165) it evident that indeed there is a negative relationship between capital and risk in the banking industry, this is to mean that changes in the credit risk and capital ratios are rather related. This fact has been proven in the case study of AAIB where as capital ratio increases credit risk decreases. Previous studies done by Jacques and Nigro (1997, 49) stated that, it can't be proven whether banks that meet the minimum requirement or those that are under-capitalized engage in riskier business activities. But it would be true to assume that banks which do not meet the minimum requirement increase their capital adequacy ratio so at to be in line with the set law, and this because of the regulatory pressure imposed on them since banks will fear the repercussions of being caught operating with a capital requirement that is below the limit.