Wednesday, September 01, 2010

Impact of Requiring More Bank Capital

Economist: Super model
WSJ: Basel: Bank Rules Won't Hurt Growth; Studies Question Bank Capital Fears
Financial Times: Banks rebound on Basel concessions; Studies refute risk of higher bank capital
Financial Stability Board: An Assessment of the long-term economic impact of stronger capital and liquidity requirements; Assessing the macroeconomic impact of the transition to stronger capital and liquidity requirements

In June, the Group of 20 nations (G20) promised to implement new international rules that would require banks to increase the amount and quality of their capital. The rules are intended as measures to prevent another financial crisis and to strengthen the resilience of the banking sector. However, the banking industry has voiced concerns, arguing that raising capital requirements would increase cost of capital, cut lending, and negatively affect the global economic recovery. According to the Institute of International Finance, the new rules would reduce the gross domestic product (GDP) by three percentage points in the U.S., the euro zone, and Japan by 2015.

In contrast, recent studies published by the Financial Stability Board (FSB) and Basel Committee on Banking Supervision (BCBS) demonstrate that the long-term benefits of raising more capital are "substantial" despite "manageable" short-term costs. According to the studies, when banks are required to raise their capital by three percentage points within four years, the absolute level of GDP would decrease by 0.6 percentage points. However, the global economy would ultimately benefit as more bank capital would lower the frequency and severity of bank crises. The net increase in absolute GDP is estimated to be around 1.7 percentage points.

Mr. Mario Draghi, Chairman of the FSB and Governor of the Bank of Italy, emphasized the importance of "appropriate phase-in arrangements" for the new rules. If banks have time to adjust to the new rules, they can reduce the short-term costs (e.g., increased loan cost or loan reduction) by using other "adjustment mechanisms" such as reducing costs, issuing equity, retaining profits, etc. In July, the BCBS postponed the implementation date-- the rules will not take full effect until 2018. The FSB and the BCBS are expected to finalize the rules before the next G20 meeting in Korea in November.

Discussion Questions: Will banks be able to survive another financial crisis without using taxpayers’ money if they increase the level and quality of capital according to the new rules? Will the new rules harm banks?

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