Why Basel III won’t hurt banks or the economy

By Felix Salmon
September 10, 2010

The new Basel III capital ratios are going to be announced this weekend, and the banks are going to complain about how much the new ratios are going to raise lending costs and hurt economic growth. The BIS, of course, has taken these complaints seriously, and has released two monster reports calculating exactly what the impact of higher capital standards will be.

The first report looks at the long-term effects of higher capital standards. They look something like this:

growth.tiff

On the x-axis, you have the capital ratio; on the y-axis, you have the long-term effect on GDP growth rates. (The effect is zero at a 7% capital ratio, since that’s what the BIS is assuming we have, globally, right now.) As you can see, at just about any realistic point on the graph, higher capital ratios increase the long-term growth rate. The green line is the conservative one: that’s the line which assumes that while financial crises are harmful in the short term, they have no long-term repercussions. The red line, more realistically, assumes that financial crises result in a permanent, if moderate, reduction in GDP.

Most of the benefit comes from smaller and less harmful financial crises. But there is cost, if a modest one, in higher loan spreads: the report calculates that each 1 percentage point increase in the capital ratio raises loan spreads by 13 basis points. And that’s assuming that banks keep their return on equity at a high 15%. If the new safer banks are OK with a 10% return on equity, then the rise in lending spreads drops to just 7bp for every percentage point increase in equity.

The second paper looks at the effects of how we get there from here. Won’t there be economic consequences to forcing banks to raise all that extra equity? Yes:

A 1 percentage point increase in the target ratio of tangible common equity (TCE) to risk- weighted assets is estimated to lead to a decline in the level of GDP by a maximum of about 0.19% from the baseline path after four and a half years (equivalent to a reduction in the annual growth rate of 0.04 percentage points over this period).

That’s barely enough to be measurable.

As an excellent story concludes in the latest issue of Global Risk Regulator,

The two reports, released in mid-August, represent a powerful counterblast to banking industry claims that the credit and liquidity reform proposals, issued by regulators on the Basel Committee last December, are likely to significantly reduce economic growth in some countries that are still recovering from the devastating financial crisis.

GRR got some reaction to the reports from banker types, and they make for pretty hilarious reading. Here’s Simon Hills, executive director of the British Bankers’ Association:

“What if they have got the analysis wrong? It is bit like the global warming question. Even if you are a global warming skeptic the impacts are so potentially catastrophic you would want to be doing something just in case you were wrong. In the same way, the authorities should err on the side of caution in calibrating the new Basel framework and determining the period over which it is to be phased in, just in case the macro economic analysis has made some simplifying assumptions that turn out not to hold true,” Hills argues.

Well, yes. But it’s pretty obvious that the potentially-catastrophic impacts are much more likely to be felt if we do too little, in terms of raising capital requirements, than if we do too much. Catastrophes come from crises, not from raising capital ratios to a level which most US banks already comfortably exceed.

The banks have their own report, of course, which paints a much more doom-and-gloom scenario — but, crucially, it assumes that their funding costs will rise if capital requirements are tightened. That doesn’t make much intuitive sense: after all, if banks have more capital, they’re safer, and if banks are safer, their funding cots should fall. But the BIS report, conservatively, doesn’t assume any decrease in funding costs: it just reckons they’ll stay where they are.

I can see the banks’ argument: if lots of banks are all forced to raise lots of new capital at the same time, then demand for new capital could exceed supply, and costs could go up. But I’m not convinced, especially since the BIS will give the banks at least four years to raise the new capital through securities issuance or just through making profits.

2 comments

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Terrific post, Felix. This is exactly what I was driving at in my comment to one of your previous posts on the subject: it may be true that raising capital requirements causes individual banks to shrink their balance sheets, but that does not necessarily imply a contraction of aggregate credit, especially when integrated over time. But I still wonder how this can be effective unless something is done about non-bank financials, which provided 2/3 of credit in the US in 2008.

Posted by Greycap | Report as abusive

The Basle reports make the popular assumption that increased borrowing costs hurt economic growth. There is actually a very good reason for supposing that the effect is exactly the opposite, that is to boost economic growth, and for a reason that has nothing to do with reducing the chance of another credit crunch. The reason is thus.

Banks indulge in maturity transformation which results in artificially low interest rates for borrowers. This results in more than the optimum amount of investment. Higher capital standards effectively reduce the extent of maturity transformation, thus the result is something nearer the optimum amount of investment. I go into this point in more detail at the following URL, see point No 4 in particular:

http://ralphanomics.blogspot.com/2010/07  /brad-delong-is-wong-on-maturity.html

Posted by RalphMusgrave | Report as abusive