The impact of capital requirements on bank lending
Jonathan Bridges, David Gregory, Mette Nielsen, Silvia Pezzini, Amar Radia, Marco Spaltro 02 September 2014
Since the Global Crisis, support has grown for the use of time-varying capital requirements as a macroprudential policy tool. This column examines the effect of bank-specific, time-varying capital requirements in the UK between 1990 and 2011. In response to increased capital requirements, banks gradually increase their capital ratios to restore their original buffers above the regulatory minimum, reducing lending temporarily as they do so. The largest effects are on commercial real estate lending, followed by lending to other corporates and then secured lending to households.
The financial crisis has led to widespread support for greater use of time-varying capital requirements on banks as a macroprudential policy tool (see for example Yellen 2010 and Hanson et al. 2011). Policymakers aim to use these tools to enhance the resilience of the financial system, and, potentially, to curb the credit cycle. Under Basel III, national regulatory authorities will be tasked with setting countercyclical capital buffers over the economic cycle.
Macroprudential policy, capital requirements, regulation, bank regulation, BASEL III, Bank of England, financial crisis, bank lending, UK
Credit ratings and regulatory risk weights
Harold Cole, Thomas F Cooley 22 June 2014
In the aftermath of the sub-prime crisis, the major credit rating agencies have been criticised for giving overly generous ratings to mortgage-backed securities. Whereas many commentators have blamed the ‘issuer pays’ market structure for distorting incentives, this column argues that the key distortion came from regulators’ use of private ratings to assign risk weights. This induced investors to focus on the risk weights attached to ratings rather than their information content, thus undermining the reputation mechanism that had previously kept ratings honest.
One of the casualties of the financial crisis has been the reputation of the major credit rating agencies. To many, the problem with the credit ratings business seems obvious:
- The ‘issuer-pays’ market structure, in which the issuers pay the agencies to rate their debt instruments, distorts incentives.
The issuers want higher ratings to lower their cost of borrowing, and can shop among raters to get higher ratings (Pagano and Volpin 2010). Seems obvious, right?
Financial markets Global crisis Microeconomic regulation
regulation, credit rating agencies, capital requirements, risk weights, sub-prime crisis, reputation
How to loosen the banks-sovereign nexus
Paolo Angelini, Giuseppe Grande 08 April 2014
The ‘deadly embrace’ between banks and their government has strengthened with the EZ Crisis. This column argues that this has mostly been consequence rather than a cause of the Crisis. Moreover, adverse bank-sovereign negative feedback depends on the economy-wide effects of the sovereign risk, not just the banks’ direct exposure. Loosening the embrace requires sound public finances and well-capitalized, well-supervised banks – including the banking union project.
Sovereign debtors and their national banking systems are closely linked through a range of direct and indirect channels. These include banks’ claims on sovereigns, semi-automatic links between sovereign and bank credit ratings, public backstops, collateral in banks’ operations, and the effects of fiscal distress on the overall economy – and thus the quality of bank loans (CGFS 2011, Bank of Italy 2013a).
EU institutions Financial markets
bank regulation, capital requirements, home bias, bank capital
Estimating the impact of changes in aggregate bank capital requirements during an upswing
Joseph Noss, Priscilla Toffano 06 April 2014
The impact of tighter regulatory capital requirements during an economic upswing is a key question in macroprudential policy. This column discusses research suggesting that an increase of 15 basis points in aggregate capital ratios of banks operating in the UK is associated with a median reduction of around 1.4% in the level of lending after 16 quarters. The impact on quarterly GDP growth is statistically insignificant, a result that is consistent with firms substituting away from bank credit and towards that supplied via bond markets.
The recent financial crisis and economic contraction that followed highlighted the crucial role that banks play in facilitating the extension of credit and enabling economic growth. This underlies the economic rationale for imposing regulations on the banking industry, including minimum capital requirements designed to mitigate risks banks would not otherwise account for in their behaviour.
regulations, bank regulation, banking, capital requirements, banks, BASEL III, credit, Macroprudential policy, bank capital
Bank capital requirements: Risk weights you cannot trust and the implications for Basel III
Jens Hagendorff, Francesco Vallascas 16 December 2013
Recent research shows that capital requirements are only loosely related to a market measure of bank portfolio risk. Changes introduced under Basel II meant that banks with the riskiest portfolios were particularly likely to hold insufficient capital. Banks that relied on government support during the crisis appeared to be well-capitalised beforehand, suggesting they engaged in capital arbitrage. Until the regulatory concept of risk better reflects actual risk, the proposed increases in risk-weighted capital requirements under Basel III will have little effect.
One of the primary purposes of bank capital is to absorb losses. Where bank capital holdings are insufficient to absorb losses, banks will either fail or – if bank failure is deemed too costly for the economy – be bailed out. In practice, banks frequently receive public funds where capital holdings are insufficient to cover losses in order to prevent bank failure. Whether or not bank capital holdings are sufficient and in line with the risk of bank portfolios is therefore an important question that is hotly debated among policymakers and in the press.
Financial markets Microeconomic regulation
Basel II, financial crisis, capital requirements, BASEL III, Basel, bank capital, risk weighting, capital adequacy
Is a 25% bank equity requirement really a no-brainer?
Charles W Calomiris 28 November 2013
There is widespread agreement that government protection of banks contributed to the financial crisis, leading to proposals to require banks to finance a larger share of their portfolios with equity instead of debt – thus forcing shareholders to absorb losses instead of taxpayers. This column argues that equity ratios relative to asset risk are what matter, not equity ratios per se. Although higher equity requirements for banks may be desirable, the costs of reduced loan supply should be taken into account.
Professor Allan Meltzer famously quipped that “capitalism without failure is like religion without sin”. If some firms are protected from failure when they cannot pay their bills, then competition is skewed to favour inefficient, protected firms. Banks whose debts are guaranteed by the state receive an unfair advantage that enables them to allocate funds inefficiently, recklessly pursue risks at the expense of taxpayers, and waste resources that would be better used by firms operating without such protection.
Financial markets Microeconomic regulation
banking, capital requirements, bank capital, bank equity, equity requirements, risk weighting, loan supply
The Future of Banking – solving the current crisis while addressing long-term challenges
Thorsten Beck 25 October 2011
For better or worse, banking is back in the headlines. From the desperate efforts of crisis-struck Eurozone governments to the Occupy Wall Street movement currently spreading across the globe, the future of banking is hotly debated. This VoxEU.org eBook presents a collection of essays by leading European and American economists that discuss both immediate solutions to the on-going financial crisis and medium- to long-term regulatory reforms.
Three years after the Lehman Brothers failure sent shockwaves through financial markets, banks are yet again in the centre of the storm.
EU institutions EU policies Europe's nations and regions Financial markets Macroeconomic policy Politics and economics Taxation
banking, capital requirements, Eurozone crisis, sovereign debt crisis, financial risks, euro bonds, ring-fencing, financial transaction tax, prudential regulation
The Dodd-Frank Act, systemic risk and capital requirements
Viral Acharya, Matthew Richardson 25 October 2011
Macroprudential regulation aims to reduce systemic risk by correcting the negative externalities caused by breakdowns in financial intermediation. This column describes the shortcomings of the Dodd-Frank legislation as a piece of macroprudential regulation. It says the Act’s ex post charges for systemic risk don’t internalise the negative externality and its capital requirements may be arbitrary and easily gamed.
The economic theory of regulation is clear. Governments should regulate where there is a market failure. It is a positive outcome from the Dodd-Frank legislation that the Act’s primary focus is on the market failure – namely systemic risk – of the recent financial crisis. The negative externality associated with such risk implies that private markets cannot efficiently solve the problem, thus requiring government intervention.
Financial markets International finance
capital requirements, Dodd-Frank Act, macroprudential regulation
Ring-fencing is good, but no panacea
Viral Acharya 25 October 2011
The Vickers Commission recommends separating commercial and noncommercial banking activities in order to protect core financial functions from riskier activities. This column warns that such ring-fencing may fail because there are still incentive problems in traditional banking activities. The accompanying risk-weighted capital requirement recommendations will address this only if we do a better job of measuring risks.
The recent report issued by the UK's Independent Commission on Banking, chaired by Sir John Vickers, provided recommendations on capital requirements and contained a proposal to ring‑fence banks – in particular, their retail versus investment activities. I view ring-fencing as potentially useful but argue that the more important question is whether the risk weights in current Basel capital requirements are appropriate.
Financial markets International finance
bank capital regulation, capital requirements, Vickers Commission, ring-fencing, risk weights
Capital, politics and bank weaknesses
Jon Danielsson 27 June 2011
A debate is raging on capital adequacy requirements for banks. The UK wants to be allowed to “top up” the agreed levels, i.e. to impose stricter capital standards than the EU minimum. This column argues the UK is right, and that the German and French opposition might be motivated by weaknesses in their banking systems.
Bank capital has emerged as a key element in the post-crisis financial regulatory reforms. Basel III is now likely to include a 7% equity-to-risk-weighted-assets capital requirement.
7% was a compromise. Some countries wanting more capital now intend to implement stricter standards unilaterally. This is making some of the others unhappy, and a bitter debate has erupted within the EU on whether individual EU member countries should be allowed to require more capital than the Basel III, and hence EU, minimums.
capital requirements, banks