Basel III, Regulatory Non-Neutrality, And Small-Bank Sustainability: Evidence from an Emerging Banking System

This paper examines whether Basel III capital and liquidity requirements are scale-neutral in emerging banking systems. Using bank-level panel data for licensed commercial banks in Kenya from 2015–2024, we exploit phased regulatory tightening to identify the causal effects of capital stringency across bank size tiers. Fixed-effects, difference-in-differences, and System-GMM estimators show that a one-percentage-point increase in effective capital requirements reduces small-bank asset and loan growth by 3.5–5.2 percentage points, while large-bank growth is largely unaffected. Mechanism tests indicate that tighter capital constraints raise marginal funding costs, weaken internal capital generation, and induce portfolio reallocation away from MSME lending toward lower-risk assets. Survival models further show that binding capital constraints significantly increase consolidation and exit risk among small banks. Counterfactual simulations suggest that proportionate regulatory calibration mitigates contractionary effects without materially weakening system stability. The findings demonstrate that uniform capital regulation is not scale-neutral when capital markets are incomplete and funding frictions differ across banks. By linking prudential regulation to banking structure, competition, and financial inclusion, this paper contributes to the literature on capital regulation and financial intermediation by highlighting how uniform prudential standards can endogenously reshape market structure in financially constrained environments.