FSB and BCBS reports on economic impact of stronger capital and liquidity requirements
31 August 2010
The Financial Stability Board and the Basel Committee on Banking Supervision publish two reports on the net economic impact of stronger capital and liquidity requirements, both during the transition phase and post implementation. They suggest only minor economic impacts.
The assessment of the net long-term economic impact of stronger capital and liquidity reforms during transition, up to full implementation, represents the joint findings from two reports prepared by the Basel committee and the FSB-BCBS Macroeconomic Assessment Group (MAG). It focused on the long-run costs and benefits of stronger regulation in terms of their impact on output. The reports are prepared as an input to the calibration of new bank capital and liquidity standards.
Regarding economic benefits, the reports find that despite a considerable uncertainty about the exact magnitude of the effect, the evidence suggests that higher capital and liquidity requirements can significantly reduce the probability of banking crises. As one would expect, the incremental benefits decline at the margin. Thus, they are relatively larger when increasing bank capital ratios from lower levels and they decline as standards are progressively tightened.
The reports assess the economic costs by using a variety of macroeconomic models under the assumption that higher capital and liquidity requirements are supposed to increase the cost of bank credit without additional non-price restrictions (e.g. credit rationing). The higher cost of bank credit lowers investment and consumption, in turn influencing the steady-state level of output.
Banks dispose of various other options in order to adjust to changes in capital and liquidity requirements other than increasing loan rates - including by reduction of ROE, reduction of operating expenses and increase in non-interest sources of income. Each of these options can significantly reduce the cost of tighter regulations. For example, a 4% reduction in operating expenses, or a 2-percentage point fall in ROE, is sufficient to absorb a 1-percentage point increase in the capital-to-RWA ratio. In practice, banks are likely to follow a combination of these strategies.
Based on the steps above, they estimate that a 1-percentage point increase in the capital ratio translates into a minor median 0.09% decline in the level of output relative to the baseline. The median impact of meeting the liquidity requirement is of a similar order of magnitude, at 0.08%. The reports conclude that the benefits of increasing capital and liquidity standards substantially exceed the potential output costs.
As a final caveat, the reports state that the results reflect the estimated net benefits associated with higher capital and liquidity standards, averaged across a number of countries over an extended period. The limitations of data are also highlighted, as well as and the inclusion of modelling assumptions in the underlying study that could cause the estimated net benefits may be higher or lower in individual cases.
