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18 September 2015

ECB: Drivers of banks’ cost of debt and long-term benefits of regulation – an empirical analysis based on EU banks

Based on a sample of EU listed banks, authors estimate the sensitivity of banks’ marginal cost of debt and analyse the potential impact of the post-crisis regulatory package. Authors find evidence of a dampening effect of banks’ capital base on the transmission of risks to market funding costs.

Since the outbreak of the 2008 financial crisis, the academic and policy debate around the impact of regulation on the financial system has become ever richer. The international overhaul of the global financial system’s regulatory structure brought about by the new rules enacted by the Basel Committee on Banking Supervision (BCBS) – the so-called Basel III standards – has been the topic of numerous papers, theoretical or empirical. Those have sought to identify the channels through which financial regulation would impact the real economy.
Most of the quantitative papers on regulatory changes focus on the short-term pain of the adjustment towards more stringent regulatory requirements. A vast strand of the literature has shown that adjusting to higher capital and liquidity requirement was detrimental to the provision of credit to the economy, as banks apply tougher credit standards and/or higher margins on the loans they provide. Despite the uncertainty around the scale of new regulations’ impact, banks will be forced to raise longer-termed, more stable and loss-absorbing funding – which is more expensive and hence will increase their overall funding costs in the short- to medium-term. Conversely, very few papers have shown estimates of the long term gains. This paper aims at contributing to fill this gap.
Authors analyse the likely impact of key pieces of regulation on banks’ funding costs, estimating how they will affect their cost of market funding by reducing markets’ perception of bank risk. The regulations considered here are: the Basel III changes to Capital and Leverage ratios, the Liquidity Coverage Ratio (LCR), the Net Stable Funding Ratio (NSFR), and the Liikanen-type changes to banks’ structural perimeter (separating trading from real economy activities).
Authors' key findings are the following. Banks’ balance sheet structure modifies the pass-through of micro and macro risks (hereafter “absolute risk”) to markets’ perception of bank risk (hereafter “relative risk”), and hence their market funding costs. As regulations aim to make banks’ balance sheet structure more resilient, they tend to reduce banks’ relative risk and their cost of market funding for a given level of absolute risk. Authors find strong evidence of a dampening effect of the capital base on the transmission of risks to funding costs, with a 1 standard deviation increase in the capital and leverage index reducing the transmission of a 1 standard deviation shock to macroeconomic risk by up to 20 basis points (bps). Their results are comparable to those of Babihuga and Spaltro (2014) (while based on a different sample and obtained from a different methodology) but have broader implications as they seek to encompass a wider array of regulations, which impact not only capital, but also funding/liquidity as well as banks’ structural perimeter. In their estimations, increased resilience on the funding and liquidity side also matters, with a 1 standard deviation increase in the index reducing the transmission of a 1 standard deviation shock to macroeconomic risk by up to 34 basis points (bps).
Finally, in line with findings in the literature, authors do not find a clear relationship regarding the impact of Liikanen-type reforms on banks’ structural perimeter. The largest banks, which tend to have larger trading activities, may be shielded by an implicit too-big-to-fail umbrella and therefore take more risk. [...]

© ECB - European Central Bank

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