Investigating the Effect of Capital Injection by the Government on the Lending Behavior of State-Owned Banks

The economies of many countries including Iran rely on their banking systems for various institutional and structural reasons. Despite an increase in the volume of financial markets in recent years and due to the low depth of the capital market, the banking system plays a key role in financing the real sectors of economy. Therefore, maintaining the lending power of banks will be one of the fundamental necessities of the country. However, on one hand, economic fluctuations and, on the other, the problems of the banking system have severely affected the performance of banks to finance economic units in recent years. This is in such a way that the poor performance of the banking system is not a hidden issue in performing its duties.  Accordingly, reforming the banking system seems necessary. In the meantime, given that capital is one of the main pillars of banks, one of the issues that is frequently raised by experts in reforming the banking system is the raise of the capital of banks. Usually, a capital crunch happens during a recession or depression, when the capital base of banks is likely to be eroded by loan losses and so on. Even if their capital deteriorates, capital crunch does not happen to banks if they can easily raise additional capital through financial markets. However, it is difficult or costly for banks to raise fresh external capital in bad times; thereby banks will be forced to cut back on their lending activity. Here is the reason why governments have made capital injections into banking sectors during financial crises. The increased capital base of banks by this policy has been expected to prevent banks from reducing their loans. In other words, the capital injection is believed to avoid a capital crunch. Scientists believe that the capital-raising of banks can cause the country's banking indicators to return to the acceptable state. It is necessary to mention that, in some cases, the government has raised the capital of state-owned banks in recent years, but there are no reports or study on the effects of implementation. Therefore, it is necessary to examine the effect of capital-raising on the performance and the lending behavior of state-owned banks.

This study employs the Generalized Method of Moments (GMM) approach to evaluate the effects of the lending behavior of government capital injection on state-owned banks as one of the banks’ performance measures in the period of 2001-2016. The data have been extracted from the Iran Banking Institute. The functional form of the model is as follows:   where: : Log Change in Lending : Lagged log Change in Lending : Government Capital Injection : Log Capital Ratio : Loan to Deposit Interest Rate Spread BC: Business Cycles

The findings show that government capital injection has a positive and significant effect on the lending behavior of state-owned banks. Furthermore, amongst the control variables, the capital ratio and the loan to deposit interest rate have positive impacts on the lending behavior of state-owned banks. However, the business cycles have negative and countercyclical effect on this behavior.

Due to the positive effect of government capital injection and capital ratio on the lending of state-owned banks and the lending behavior of countercyclical state-owned banks, and considering that state-owned banks are faced with many problems in recent years, such as multiple government duties, non-repayment of government debts, and  non-performing loans of legal and real  persons of  NGOs, which causes these banks to face serious capital challenges, it is suggested that the government force them to increase lending by capital injection. This suggestion is due to the current recession in the country. Also, after capital injection, the government must impose restrictions on loans to real producers.In addition, It should be noted that, if the government forces banks to increase lending with low interest without creating the necessary infrastructure, this can pose moral hazards to banks. Furthermore, the amount and the source of capital-raising are issues that the government should pay special attention to in programs of capital raising.It is suggested to create specific procedures and standards for the capital-raising of state-owned banks and avoid unconventional methods. This can be done in the form enacting corresponding rules. Furthermore, according to the statistics provided in this study regarding the capital adequacy ratio of banks, most state-owned banks in particular and the banking system in general are far from the standards of the Basel Committee. This indicates the necessary of capital-raising of these banks as a solution to reform the capital structure and the fulfilment of international regulations.