The Costs and Benefits of Bank Capital—A Review of the Literature

Martin Birn,Tord Krogh,Missaka Warusawitharana,Valerio Scalone,Michael Straughan,Diana Hancock,Alexander Von Hafften,Ajay Palvia,Simon Firestone,Arzu Uluc,Hitoshi Mio,Olivier De Bandt,Matías Gutiérrez Girault,Donald Morgan

doi:10.3390/jrfm13040074

Abstract

In 2010, the Basel Committee on Banking Supervision published an assessment of the long-term economic impact (LEI) of stronger capital and liquidity requirements. This paper considers this assessment in light of estimates from later studies of the macroeconomic benefits and costs of higher capital requirements. Consistent with the Basel Committee’s original assessment, this paper finds that the net macroeconomic benefits of capital requirements are positive over a wide range of capital levels. Under certain assumptions, the literature finds that the net benefits of higher capital requirements may have been understated in the original committee assessment. Put differently, the range of estimates for the theoretically optimal level of capital requirements—where marginal benefits equal marginal costs—is likely either similar to, or higher than was originally estimated by the Basel Committee. The above conclusion is however subject to a number of important considerations. First, estimates of optimal capital are sensitive to a number of assumptions and design choices. For example, the literature differs in judgments made about the permanence of crisis effects as well as assumptions about the efficacy of post crisis reforms, such as liquidity regulations and bank resolution regimes, in reducing the probability and costs of future banking crisis. In some cases, these judgements can offset the upward tendency in the range of optimal capital. Second, differences in (net) benefit estimates can reflect different conditioning assumptions such as starting levels of capital or default thresholds (the capital ratio at which firms are assumed to fail) when estimating the impact of capital in reducing crisis probabilities. Finally, the estimates are based on capital ratios that are measured in different units. For example, some studies provide optimal capital estimates in risk-weighted ratios, others in leverage ratios. And, across the risk-weighted ratio estimates, the definition of capital and risk-weighted assets (RWAs) can also differ (e.g., tangible common equity (TCE) or Tier 1 or common equity tier 1 (CET1) capital; Basel II RWAs vs. Basel III measures of RWAs). A full standardisation of the different estimates across studies to allow for all of these considerations is not possible on the basis of the information available and lies beyond the scope of this paper. This paper also suggests a set of issues which warrant further monitoring and research. This includes the link between capital and the cost and probability of crises, accounting for the effects of liquidity regulations, resolution regimes and counter-cyclical capital buffers, and the impact of regulation on loan quantities.

Highlights

This report considers the analysis of the assessment by the Basel Committee on Banking Supervision (BCBS) of the long-term economic impact (LEI) of stronger capital and liquidity requirements (BCBS 2010) in light of more recently published analyses
The definition of capital ratios can vary: the LEI was based on a mapping of banks’ tangible common equity (TCE) to Basel II risk-weighted assets (RWA) while more recent studies are based on actual Basel III capital ratio data, which hinders comparison
To augment the full-fledged optimal capital studies, we consider a broader set of analyses on the four components of the marginal benefits and costs of additional capital discussed in the previous section

Summary

Introduction

This report considers the analysis of the assessment by the Basel Committee on Banking Supervision (BCBS) of the long-term economic impact (LEI) of stronger capital and liquidity requirements (BCBS 2010) in light of more recently published analyses. With that simple stabiliser/drag framing, and postponing details, the net marginal benefits of more bank capital k can be expressed in stylised form as: Net benefits (k) = reduced crisis probability (k) × crisis cost − output drag (loan spreads (k)) In this approach, more capital k is beneficial as long as the stability benefits of higher capital minus the economic drag (the net benefits) is positive holding all else, including other post-crisis regulations, constant (see Appendix A for a recap of the results in BCBS (2010)). New estimates from this literature raise the question of whether the stabilising effect of bank capital operates more from reducing the costs of crisis, rather than their probability. This section discusses possible improvements to the LEI framework

Basel Committee Long-Term Economic Impact Analysis and Subsequent Studies

Stability Benefits of Bank Capital

Cost of a Banking Crisis

Capital Requirements and Bank Funding Costs

Impact of Higher Loan Spreads on GDP

Results from the Research Task Force Survey and Academic Literature