The regulatory capital reform for banks increases capital costs and credit spreads charged on clients. However, it also clearly reduces the tail risk of future banking system crises. And these crises have historically subtracted on average about 100% of an annual GDP overtime. Hence, a BIS paper finds that long-term growth benefits outweigh costs. One implication may be that once capital adjustment is complete and higher capital ratios are firmly established regulation headwinds for equity and credit markets turn into tailwinds.

Fender, Ingo and Ulf Lewrick (2016), “Adding it all up: the macroeconomic impact of Basel III and outstanding reform issues”, BIS Working Papers No 591, November 2016.

The post ties in with our summary page on systemic risk through the regulated banking system.

The below are excerpts from the paper. Headings and some other cursive text has been added for context and convenience of reading.

Basel III in a nutshell

“The regulatory community is in the process of wrapping up the Basel III package…The cornerstone of the Basel III framework is enhanced risk-weighted capital requirements (RWR). Compared with pre-crisis regulations, the RWR have been substantially tightened for all three of their components: the RWR numerator, i.e. the definition and quality of bank capital, the denominator, i.e. the computation of risk-weighted assets (RWA), and the required capital ratio itself. Banks now have to
[i] comply with a minimum risk-weighted capital requirement of 4.5% Common Equity Tier 1 (CET1) capital to risk-weighted assets;
[ii] meet a 6% Tier 1 capital ratio (comprising a more broadly defined Tier 1 capital element as numerator); and
[iii] maintain an additional capital conservation buffer of 2.5% in terms of CET1 capital to RWA.”

“The leverage ratio (LR) requirement, in particular, is designed to restrict the build-up of leverage in the banking sector and to backstop the existing RWR with a simple, non-risk-based measure. The leverage ratio is defined as Tier 1 capital divided by an exposure measure, which consists of the sum of all on-balance sheet exposures, derivative positions, securities financing transactions and certain off-balance sheet items. In January 2016, the Group of Central Bank Governors and Heads of Supervision…confirmed that the LR would be set at a minimum level of 3%. At the same time, the option of introducing additional leverage ratio requirements for global systemically important banks (G-SIBs) was discussed.”

The increase in capital requirements

“We draw on… historical time series on risk-weighted assets and on the leverage ratio exposure measure for a sample of more than 100 banks from 14 advanced economies, covering mainly the period from 1994 to 2012.”

“Making the conservative assumption that additional capital needs would be met by core tier 1 capital… the combined Basel III requirements would raise the CET1/RWA ratio for the entire banking system by approximately 2.7 to 3.4 percentage points. This comprises:
[i] a 1.5 percentage point (ppt) increase due to higher minimum risk-weighted capital requirements, raising the CET1/RWA ratio from an initial 5.5% to 7% (i.e. the 4.5% minimum and the 2.5% capital conservation buffer);
[ii] 0.7 ppt due to the 3% minimum leverage ratio requirements;
[iii] 0.4 ppt assuming a (flat) 1% higher loss absorbency requirement for all global systemically important banks; and
[iv] 0.1 to 0.8 ppt given the assumption of a 0.5% and 2% LR surcharge for global systemically important banks, respectively.”

“We need to account for the impact of the more stringent definition of regulatory capital as well as the increase in risk-weighted assets, given the new regulatory framework. Based on publicly available data, we estimate that the conversion factor for the transition from Basel II to Basel III capital ratios is about 0.78 [i.e. 1 percentage point core tier 1 capital ratio under Basel III corresponds to 0.78 percentage point for that ratio under Basel II].”

The economic cost of higher capital requirements

“The estimated costs of regulation…are derived from the assumption that banks counterbalance any decline in their return on equity by raising their lending spreads. As a result, real economy borrowing costs may rise, translating into lower investment and equilibrium output. More specifically, the long-term economic impact study feeds the estimated increase in lending spreads into a variety of macroeconomic models.”

The impact of a 1 percentage point increase in capital ratios is estimated to be around 9% of GDP by the long-term economic impact study and between 1% and 12% in other studies.

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“In terms of the cost of regulation, the transition of capital and RWA definitions suggests that a 1 percentage point increase in the CET1/RWA ratio translates into a 0.12% median decline in the level of output relative to its baseline (with the corresponding value for the liquidity requirements being a one-off 0.08% decline in the output level).”

The economic cost of banking crises

GDP impact measures…are derived from academic studies of historical crisis experiences. The …median cost of systemic banking crises in these studies is 63% of GDP in net present value terms. But the variation in these cost estimates is large. Most of these studies of the cost of financial crises…rely solely on pre-2007 data, missing the impact of the most recent crisis episode…Ball (2014)…estimates…that the weighted average cumulative loss from the global financial crisis across all OECD countries amounts to about 180% of pre-crisis GDP…Haldane (2010)…places the present value of output losses from the recent crisis at somewhere between 90% and 350% of world GDP.”

“Assuming cumulative output losses of the recent [global financial] crisis at 200%…and losses from previous crises of 63% gives a back-of-the-envelope estimate of about 100% of GDP in net present value terms, based on the weighted average loss of output per crisis.”

“Estimates by the European Commission (2014) based on the contraction of EU GDP during the Great Financial Crisis imply costs of similar magnitude (98.59% of a weighted average of EU GDP).”

The benefits of reduced banking crises probability

“[The long-term economic impact study] assesses the expected benefits of higher capital requirements in the new steady state that arise from the reduction in the expected output losses from systemic banking crises…Conceptually, the…benefit component is derived by multiplying the probability of systemic banking crises, given minimum capital requirements, with the expected macroeconomic costs of such crises should they occur. To derive the first of these elements the long-term economic impact study uses a range of ‘probit’ models as well as portfolio credit risk analyses…it then yields a functional expression of crisis probabilities and capitalisation levels with diminishing marginal returns.”

“Starting from a capital ratio of 5.5% CET1/RWA, the long-term economic impact schedule estimates a 4.8% probability of a systemic banking crisis. The amount of reduction in percentage points, given the expected increase in capital [is between 1.5 and 2.5 and] follows from [the table below, line 2.1].”

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The net growth effect

“We find that the Basel III enhancements yield sizeable net economic benefits, in a range of about 0.5% to 2.0% of GDP.”

“Overall, despite rising amounts of required additional capital, estimated net marginal benefits [of further capital requirement beyond Basel III] remain positive and increasing for the full range of alternative crisis cost assumptions… ample room is available for national authorities to further raise regulatory capital.”

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