The Reciprocal Relationship between Bank Capital and Risk and Testing the Partial Adjustment Hypothesis Using a Simultaneous Equations System: An Applied Study of a Sample of Iraqi Private Commercial Banks Listed on the Iraq Stock Exchange for the Period
DOI:
https://doi.org/10.71285/icpt.v3i2.73Keywords:
bank capital, credit risk, partial adjustment hypothesis, simultaneous equations, 3SLS, Iraqi banksAbstract
This study is designed to investigate the relationship between capital and risk in private commercial banks of Iraq and how each adjust to their target under the partial adjustment hypothesis. The study relies on data from six banks listed on the Iraq Stock Exchange for the time period 2012 to 2024 (69 annual observations after differencing, obtained from the audited financial statements). Capital is defined as the percentage of equity in total assets, and risk is defined as the percentage of non-performing loans over gross loans. An estimation method that uses three-stage least squares (3SLS) and bank fixed effects is used to estimate a two-equation simultaneous system.
The results showed that there is a unidirectional relationship between the variables between capital and credit risk, where a rise in capital would lead to a decrease in credit risk with a coefficient of −0.841 (p = 0.036), and a rise in risk would have no effect on book capital (p = 0.301). The annual adjustment to banks' capital is 75% of the gap, and their adjustment of risk is 60%, so half of the gap will be closed in about six months for capital and nine months for risk. The effect of the capital adequacy buffer in both equations over the Central Bank of Iraq minimum requirement (12%) is not significant, due to the average of the sample was about 113% as capital adequacy ratio. The negative association of capital with risk persists with the same negative sign in all robustness specifications based on non-performing loans, and is significant at the 10% level in five of the nine specifications. The study suggests that capital requirement needs to be related to the credit quality, and not just size.
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