How do banks perform under Basel III? Tracing lending rates and loan quantity

Abstract

In late 2010, the Basel Committee on Banking Supervision issued the Basel III document enumerating measures focused on improvements in the definition of regulatory capital, introduction of a leverage ratio as a backstop for risk-based capital requirement, capital buffers, enhancement of risk coverage through improvements in the methodology to measure counterparty credit risk and liquidity measurement standards. This study investigates the impact of the new capital requirements introduced under the Basel III framework on bank lending rates and loan growth. Higher capital requirements, by raising banks’ marginal cost of funding, lead to higher lending rates. The data presented in the paper suggest that assuming a 1.3 percentage point increase in the equity-to-asset ratio to meet the Basel III regulations, the country-by-country estimations imply a reduction in the volume of loans by an average 4.97 percent in the long run for the banks in countries that experienced a crisis and by 18.67 percent for the banks in countries that did not experience a crisis. The wide variance in the results reflects cross-country differences in the elasticity of loan demand with respect to loan interest rate and bank's net cost of raising equity.