17 December 2014

Vox EU: Higher capital requirements: The jury is in

Column by BIS Chief Economist Steve Cecchetti.

Lending spreads and interest margins are nearly unchanged, while credit growth remains robust everywhere but in Europe. Perhaps the requirements should be raised further. 

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 (2010) is the most sensationalist example of the former, and the Macroeconomic Assessment Group (2010a and 2010b) 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.

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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.

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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 two-fold. 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.

Full article on Vox EU

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