01 December 2015

Financial Stability Paper: Measuring the macroeconomic costs and benefits of higher UK bank capital requirements

This paper assesses whether baseline bank capital requirements are appropriate for the UK, given the characteristics of the banking system and economy, and taking into account the recent development of a bank resolution regime and requirements for additional capacity to absorb losses in resolution.

In November, G20 leaders endorsed standards agreed by the financial Stability Board for global systemically important banks to meet a minimum amount of Total Loss-Absorbing Capacity (TLAC). In December, the Bank of England will, in line with statutory requirements, consult on proposals for additional loss-absorbing capacity for other UK banks.

This paper uses a framework that measures and compares the macroeconomic costs and benefits of higher bank capital requirements. The economic benefits derive from the reduction in the likelihood and costs of financial crises. The economic costs are mainly related to the possibility that they might lead to higher bank lending rates which dampen investment activity and, in turn, potential output.

Using this conceptual framework, studies conducted in the aftermath of the financial crisis, such as the one by the Basel Committee on Banking Supervision (BCBS), found appropriate Tier 1 capital ratios of 16-19% - well above the agreed Basel III standards. But our analysis suggests that:

• Once resolution requirements and standards for additional loss-absorbing capacity that can be used in resolution are in place, the appropriate level of capital in the banking system is significantly lower than these earlier estimates, at 10-14% of risk-weighted assets.
• The appropriate level of bank capital varies significantly with the risk environment in which the banking system operates. Our main conclusions relate to typical risk environments. But we also find that in periods where economic risks are elevated – such as after credit booms – the appropriate level of capital would be much higher.
• It would be inefficient to capitalise the banking system for these elevated risk environments at all times, based on our analysis of the economic costs of higher bank capital levels. This motivates the use of time-varying macroprudential tools, such as the countercyclical capital buffer.

Full paper

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