The effects of banking regulation in the South African economy using computable general equilibrium model

Abstract

The importance of regulation for the banking sector cannot be over emphasised as failure to adequately regulate the banking sector usually leads to financial crisis including collapse of major financial institutions. As such any method used for regulating the sector must ensure that almost all possible risks are detected. The Computable General Equilibrium (CGE) model considers interactions amongst various entities of the economy and so when used for regulation could detect potential risks. The CGE model has been used widely as a powerful technique for quantitative analysis to answer many "what if" questions about the economy including the South African economy. However, not much of its use is applied to the banking sector especially in South Africa. In particular, the effect of regulatory policy intervention in the banking sector is little known when it comes to modelling with the CGE model in South Africa. In this study, a CGE model is developed to cover the banking sector in South Africa. Emphasis is placed on modelling the possible effect of regulatory policy on the economy. The CGE model performed well as a tool for regulation and risk assessment for the banking sector in South Africa. It was established that default penalty has a higher effect on the banks' profits and interest rates than capital requirement infringement penalty. The results also suggest that interest rate targeting has more controlled effects than monetary base targeting since pecuniary externalities are reduced. Default penalty and capital adequacy requirement (CAR) violation penalty have opposing effect on banks profits and that default penalty dominates CAR violation penalty. During periods of adverse economic conditions, tightening capital requirement regulation further reduces banks pro fits. This study should therefore be a source of providing methodology for regulators of the banking sector and policymakers in South Africa to apply the CGE model for risk assessment and for future