Media Briefings

OPTIMAL BANK CAPITAL: TO REDUCE THREAT OF SYSTEMIC FINANCIAL CRISES, BASEL III REQUIREMENTS SHOULD BE MUCH HIGHER

  • Published Date: March 2013

The desirable amount of equity funding for banks to use is very much larger than they have had in recent years and higher than agreed under the Basel III framework. That is the central conclusion of research by Professor David Miles and colleagues, published in the March 2013 issue of the Economic Journal. Their results suggest that the optimal amount of capital is twice as great as the Basel III requirements of 10% of risk-weighted assets.

What’s more, the study finds, even proportionally large increases in bank capital are likely to result in only a small long-run impact on the borrowing costs faced by bank customers. And substantially higher capital requirements could create very large benefits by reducing the probability of systemic banking crises.

The authors conclude:

‘We believe that our results show the need to break out of the way of thinking that leads to the “equity is scarce and expensive” conclusion.

‘That would help us get to a situation where it will be normal to have banks finance a much higher proportion of their lending with equity than had been assumed in recent decades to be acceptable.

‘That change would be a return to a position that served our economic development rather well, rather than a leap into the unknown.’

The study begins by noting that in the financial crisis, many highly leveraged banks found that their sources of funding dried up as fears over the scale of losses – relative to their capital – made potential lenders pull away from extending credit. The economic damage done by the fallout from this banking crisis has been enormous. Rethinking what are acceptable levels of leverage for banks – through setting requirements on the amount of equity (or capital) they hold – is therefore crucial.

The Basel III framework that is being implemented internationally will see banks come to use more equity capital to finance their assets than was required under previous sets of rules. This has triggered warnings from some about the cost of requiring banks to use more equity.

But measuring those costs requires careful consideration of a wide range of issues about how shifts in funding affect required rates of return and how costs are influenced by the tax system. It also requires a clear distinction to be drawn between costs to individual institutions (private costs) and overall economic (or social) costs. Without a calculation of the benefits of having banks use more equity (or capital) and less debt, no estimate of costs – however accurate – can show the optimal level of bank capital.

The study reports estimates of the long-run costs and benefits of having banks fund more of their assets with loss-absorbing capital (equity) rather than debt. The benefits come because a larger buffer of truly loss-absorbing capital reduces the chance of banking crises, which, as both past history and recent events show, generate substantial economic costs.

The offset to any such benefits comes in the form of potentially higher costs of intermediation of saving through the banking system. The cost of funding bank lending might rise as equity replaces debt and such costs can be expected to be reflected in higher interest rates charged to borrowers. That in turn would tend to reduce the level of investment with potentially long-lasting effects on the level of economic activity.

The study finds that even proportionally large increases in bank capital are likely to result in a small long-run impact on the borrowing costs faced by bank customers. Even if the amount of bank capital doubles, the estimates suggest that the average cost of bank funding will increase by only around 10-40 basis points. (A doubling in capital from current levels would still mean that most banks were financing more than 90% of their assets with debt.)

But substantially higher capital requirements could create very large benefits by reducing the probability of systemic banking crises. The researchers use data from shocks to incomes from a wide range of countries over a period of almost 200 years to assess the resilience of a banking system to these shocks and how equity capital protects against them.

In the light of the estimates of costs and benefits, they conclude that the amount of equity funding that is likely to be desirable for banks to use is very much larger than banks have had in recent years (though not much different from levels that were normal for most of the past 150 years) and higher than agreed under the Basel III framework.

The Basel III agreements will put capital requirements for the largest banks at around 10% of risk weighted assets. These results suggest the optimal amount of capital is likely to be around twice as great.

Were banks, over time, to come to use substantially more equity and correspondingly less debt, they would not have to alter their stock of assets or cut their lending dramatically. The change that is needed is on the funding side of banks’ balance sheets – on their liabilities – and not their assets.

The researchers argue that the idea that banks must shrink lending to satisfy higher requirements on equity funding is a non sequitur. But, they note, there is a widely used vocabulary on the impact of capital requirements that encourages people to think this will happen. Capital requirements are often described as if extra equity financing means that money is drained from the economy – that more capital means less money for lending.

The authors respond thus:

‘This is pretty much the opposite of the truth. At the risk of stating the obvious: equity is a form of financing; other things equal, a bank that raises more equity has more money to lend – not less.

‘Nor is the capital in any sense “tied up”; it represents funding available to a bank to lend or to acquire other assets.

‘In retrospect, we believe a huge mistake was made in letting banks come to have much less equity funding – certainly relative to unweighted assets – than was normal in earlier times.

‘This was because most regulators and governments seem to have accepted the view that “equity capital is scarce and very expensive” – which in some ways is a proposition remarkable in its incoherence.’

ENDS

Notes for editors: ‘Optimal Bank Capital’ by David Miles, Jing Yang and Gilberto Marcheggiano is published in the March 2013 issue of the Economic Journal.

David Miles is a member of the Bank of England’s Monetary Policy Committee. Jing Yang is at the Bank for International Settlements. Gilberto Marcheggiano is at Goldman Sachs.

The views in this paper are those of the authors and not those of the institutions where they work.

For further information: contact Romesh Vaitilingam on +44-7768-661095 (email: romesh@vaitilingam.com).