The jury is in on higher capital requirements

VoxEU

During the Basel III debate, a key concern was that higher capital requirements might damage economic growth. By forcing banks to increase their capitalisation, long-run growth would be permanently lower and the adjustment itself would put a drag on the recovery from the Great Recession. Unsurprisingly, the private sector saw catastrophe, while the official sector was more sanguine.

The Institute of International Finance is the most sensationalist example of the former, and the Macroeconomic Assessment Group one of the most staid cases of the latter.

With four years of evidence behind us, my reading is that the optimists were not optimistic enough. Since the crisis, capital requirements and capital levels have both gone up substantially. Yet, outside the still-fragile Eurozone, lending spreads have barely moved, bank interest margins have fallen, and loan volumes are up. To the extent that more demanding capital regulations had any macroeconomic impact at all, it would appear to have been offset by accommodative monetary policy.

In what follows, I summarise the evidence for this conclusion and its policy implications. For more details, see CEPR Policy Insight 76.

Higher capital requirements and capital levels

It is important to appreciate how much higher the new international capital standards are. Basel III is more rigorous than its predecessor in three fundamental ways: the definition of what constitutes capital is tighter, the coverage of what counts as an asset is broader, and the required ratio of the two is higher. Overall, I estimate that risk-weighted capital requirements increased by factor of 10 to 20 (albeit from a level that was abysmally close to zero).

Not only have requirements gone up, but capital levels have, too. According to the Basel Committee on Banking Supervision's (various years) quantitative impact assessments, from the end of 2009 to the end of 2013, capital for the 102 largest global banks (based on the new stringent definitions) rose from 5.7 per cent to 10.2 per cent of risk-weighted capital. A recent study by Cohen and Scatigna shows that two-thirds of this increase has been from retained earnings, with the remaining third coming from capital issuance.

Margins and costs were squeezed while lending grew

Contrary to the predictions of the private-sector doomsayers, as banks were increasing their capital levels, they were shrinking their return on assets, cutting their net interest margins and reducing their operating costs. BIS (2014) provides data on banks in 15 large advanced and emerging-market countries. Comparing 2013 results with the 2000–2007 average, we see that return on assets fell roughly 40 basis points, interest rate spreads fell by an average of more than 30 basis points, and operating costs by closer to 75 basis points. At the same time, bank credit to the non-financial private sector was rising.

… except in the eurozone

I should note that Europe is something of an exception. There, lending spreads are generally up and loans down. The explanation for this is likely twofold. First, there is the way in which supervisors conducted European stress tests and capital exercises. Instead of requiring banks to raise additional capital to offset a shortfall -- as the 2009 US stress test did -- authorities allowed them to meet capital ratios by shedding assets.

In fact, eurozone banks did not raise capital. Instead, they reduced both their total assets and their risk-weighted assets. Second, a number of continental European banks remain under pressure to further raise their levels of capitalisation.

The eurozone's problems are consistent with the commonly held belief that banks with debt overhangs do not lend – a belief that is substantiated by data of the sort that I describe in my CEPR Policy Insight. Europe's banks still need capital to reduce the overhang.

Fears about higher capital requirements have not been borne out

I draw two principal conclusions from this accumulated evidence. First, the predictions that higher capital requirements would drive up interest margins and reduce credit volumes are very clearly at odds with the evidence of smaller spreads and increased lending. Insofar as there was any macroeconomic impact at all, it appears to have been inconsequential. Instead, it is high levels of capital that lead to healthy lending.

Implications for countercyclical capital buffers

Second, the evidence is bad news for the Basel III's countercyclical capital buffer. The idea of the buffer is that, when they are confronted with a credit boom, authorities should raise capital requirements to limit the expansion. By using prudential tools to lean against credit booms, regulators can help to stabilise the financial system and the real economy. But, as Aiyar et al note, for the countercyclical buffer to work, there are three preconditions: capital requirements have to bind before they are raised, equity has to be costly and difficult to raise in the short term, and alternatives to bank credit have to be relatively unavailable and costly.

On all three counts, the experience I have summarised is not very encouraging. Lending spreads do not appear to be the first-order response to higher capital requirements; loan volumes do not look sensitive to changes in capital so long as banks are reasonably well capitalised; and at the stage in the business cycle when the countercyclical buffer would be needed, banks' business is likely to be booming and profitable, making it cheaper and easier to raise equity.

Concluding remarks

We need to continue to study this episode, doing a proper statistical analysis that controls for macroeconomic conditions and policy responses. At this stage, however, it seems reasonably safe to conclude: (1) We should seriously consider requiring further additions to bank capital, given that the social costs of post-crisis capital increases appear to have been small; and (2) the efficacy of time-varying capital requirements in moderating credit fluctuations is questionable.

This article first appeared in VoxEU. Reproduced with permission.