A PRICE WORTH PAYING TO MAKE BANKS SAFER / THE FINANCIAL TIMES COMMEN TARY & ANALYSIS ( VERY HIGHLY RECOMMENDED READING )

A price worth paying to make banks safer

By Stephen Cecchetti

Published: August 18 2010 20:21

It is now three years since financial authorities began working feverishly to ward off a systemic collapse. They have been providing emergency assistance at the same time as they seek to prevent a relapse. And, like good doctors adhering to their Hippocratic oath, officials are on guard so that they do no harm. With this in mind, they are examining to what extent the benefits of more stringent regulation and supervision outweigh the potential costs.

A clear answer comes from two papers released this week by the Financial Stability Board (FSB) and the Basel Committee on Banking Supervision (BCBS). The first study looks at the long-term impact of stronger capital and liquidity requirements,* the second at the transitional economic impact as the requirements are phased in.** Taken together, they show that the benefits of such measures will be significant, while the costs are likely to be very modest.

The motive for regulation is that, if banks are left to their own devices, they hold too little capital and too little liquidity. Lower capital means higher returns on equity but a smaller buffer against loan defaults and investment losses. Less liquidity, implying a higher fraction of long-term assets funded with short-term debt, raises profits but heightens exposure to sudden withdrawals and difficulties in rolling over debt.

As we have learnt over the past three years, the upside of these risks accrues to banks’ shareholders and managers, but the size of capital and liquidity cushions determines how much of the downside risk is borne by all of us. In any given country, serious financial crises occur every 20 to 25 years, bringing with them deep recessions. It is with the aim of reducing the frequency, severity and public costs of such crises that the leaders of the Group of 20 are committed to significantly increasing the levels of capital and liquidity in their national banking systems. The Basel Committee’s report shows that the benefits of the consequent decline in the probability of a costly crisis are substantial.

But, even if the long-term benefits are demonstrable, what about the short-term costs of implementing strong requirements?

This is the question addressed by the FSB/BCBS Macroeconomic Assessment Group (MAG), which draws together the modelling expertise of two dozen national authorities and international organisations. We report that, if the new requirements are phased in over four years, each percentage point increase in required capital subtracts 0.04 to 0.05 percentage points from annual growth during the implementation period. Output then recovers to its original path.

The adjustment costs of implementing higher capital requirements arise from the fact that equity investors – suppliers of the bank’s risk capital – require higher returns than depositors. So, higher capital requirements mean higher funding costs – costs that banks will try to recover by raising loan rates, shrinking their balance sheets or making savings elsewhere. But it is also possible that, as banks become safer, markets will require a lower return on equity, tempering the pressure on funding costs.

Focusing on the implications for borrowing costs and assuming no other adjustments, MAG researchers estimated that banks’ lending rates would rise by about 15 basis points for each percentage point increase in capital. Having to pay more to borrow, companies would start fewer new investment projects, slowing the level of overall economic activity. But, as the financial system adjusts, these costs will dissipate and then reverse, returning GDP to the path it would otherwise have followed. The estimated impact of higher liquidity standards is similarly quite small.

Studies published by banks come to different conclusions. In some cases, estimates are as much as 10 times higher. Why such a big difference? One reason is that industry studies assume a much larger increase in the lending rate, reflecting the withdrawal of implicit government support. But as the industry studies also acknowledge, they assume no changes in dividends, compensation and operational efficiency, nor have they taken account of the benefits coming from a more resilient financial system, including the lower funding premiums that safer banks need to pay.

A clear lesson of this crisis was that the safeguards in place were too weak. But reinforcement is not free. Fortunately, the short-term adjustment costs are likely to be small and transitory, while the benefits of a stronger and healthier financial system will be there for years to come.

* ‘An assessment of the long-term economic impact of the new regulatory framework’, Basel Committee 2010; ** ‘Assessing the macroeconomic impact of the transition to stronger capital and liquidity requirements’, BIS 2010

The writer is the economic adviser of the Bank for International Settlements and chair of the Macroeconomic Assessment Group


Copyright The Financial Times Limited 2010.