Bank-capital requirements and growth

Jean Pisani-Ferry (Aug 22, 2010)

Economist’s Economics by Invitation blog

The debate over bank-capital regulation has all the ingredients of what economists love and other
people hate. The Basel Committee on Banking Supervision and the Financial Stability Board have just
released two reports on the long-term implications of tighter capital regulation – higher capital-to-
assets ratios and the introducing of new liquidity requirements – and on the short-term effects of
their introduction. In a nutshell, the first document claims that in the steady state the net benefits of
these regulatory reforms would be substantial as the gains from reducing the severity and frequency
of banking crises outweigh by a wide margin the negative impact of increasing intermediation costs.
The second document then claims that transiting to this new steady state will necessarily involve
costs (as banks would likely increase lending spreads and reduce credit volumes) but that these
costs should remain “modest”.

No doubt the central bank economists who drafted these reports think they have done a good job:
benefits and costs have been evaluated thoroughly and it is now up to the G20 leaders and the
regulators to decide on implementation. One can almost hear them whispering ‘Yes, ministers, there
are undoubtedly short-term economic costs involved. Some additional employees, alas, will lose
their job. But as responsible politicians, you will certainly agree with us that action is required and
will be beneficial. Unless your discount rate is, well, astonishingly high.’

The starting point of any discussion is that financial crises are extraordinarily costly and that this
one is no exception: Andrew Haldane from the Bank of England estimated in a recent paper that the
present value of all output losses involved could easily reach 100% of world GDP (meaning that the
crisis could be equivalent to the evaporation of one year of world production and income). By such a
yardstick, virtually anything that reduces the probability of financial catastrophes is worth
undertaking. The Basel report finds that starting from current levels of capitalization, a one
percentage-point increase in the capital ratio would permanently reduce the frequency of crises by
one-third, while increasing loan spreads by some 13 basis points. This would at most lead a few bank
customers to turn to alternative sources of finance, with most likely no discernible effect on GDP. It is
like saying that imposing marginally heavier car bodies would reduce the road accidents death toll by
one third, and indeed the measure has been in force for a long time.

What is astonishing here is how small the costs are with respect to potential benefits. They are in
fact much smaller than in many other fields where public policy imposes economically costly safety
requirements – beyond road safety think, for example, of the environment or public health where the
precautionary principle is used as a guidance for decisions. So there seems to be no reason to
hesitate.

© Bruegel 2010 1
The next and more difficult question is whether the magnitude of transition costs may change this
conclusion. Quite correctly, the Basel reports deal with them entirely separately. They do not attempt
at finding a common metric between the steady-state assessment and the evaluation of transition
costs, and rather present the two sets of results independently. The question here is obviously that
making banks, some of which are still ailing, subject to new regulation may lead them to cut lending
even more, thereby further weakening the pace of the recovery. A judgment call is needed here as
regards the timing and speed of the regulatory tightening and it is not an easy one.

The report’s claim that costs are modest is based on the evaluation that if introduced gradually over
four years, a one-percentage point increase in the banks’ capital ratio would result in lowering GDP by
about 0.2 percentage points. This surely seems small in comparison to the cost of crises but the
issue is a little bit more complex than it looks. To start with, these numbers correspond to a one
percentage-point increase in the capital ratio, which may not be enough – the threshold used for the
stress test was for example two percentage points above the previous minimum. Second, the
assumption is made that monetary policy will be able to offset part of the shock, which may not be
true (because interest rates are at near-zero level already or, in the euro area, because the impact is
higher for some countries while the ECB responds to the aggregate situation only). Third, the report
oddly finds that raising the target capital ratio would have a significantly more adverse effect in the
US than in the euro area in spite of the latter’s much more pronounced reliance on bank-based
financing, so there is uncertainty in the estimates. Putting all these factors together suggests that
the impact of new regulations on countries where banks are significantly under-capitalised could
easily be three or four times larger than the headline figure – say, in the vicinity of three-quarters of
a percentage point at a four-year horizon, a bit less than 0.2 per cent per year.

Such a perspective may give second thoughts to policymakers. To reduce growth by this order of
magnitude at a time when private agents have not completed their deleveraging cycle and
governments are starting their own one may be too much of a good thing. It could increase the
probability of a prolonged period of near-stagnation and the associated risk of turning crisis-induced
unemployment into structural unemployment. Furthermore, tighter credit standards over a prolonged
period may involve longer-term costs as damages are likely to fall disproportionately on the cash-
poor, fast-growing companies, with consequences for innovation, productivity and ultimately the
growth potential.

This does not mean banks should be granted a regulatory holiday and forget the need to recapitalize.
But this suggests first that timing matters. Policymakers should refrain from imposing
simultaneously a fiscal shock and a regulatory shock. Best would be to enact now regulatory
standards to me met in several years (which seems likely to be the case). Second, the existence and
magnitude of transition costs leads to qualify the previous observation that anything that reduces
the probability of financial crises is worth undertaking. Higher capital ratios and liquidity ratios are

© Bruegel 2010 2
only one of the several approaches that can be used to make the financial system safer. If other
approaches – say capital insurance or a Volcker rule of some sort – are able to achieve the same
result at lower cost, they are worth considering and this reopens the debate on the menu of reforms.
These alternatives are however not considered in the Basel reports.

© Bruegel 2010 3