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Basel 3 to Blame for Sluggish Economic Growth?

Analysis

Basel 3 to Blame for Sluggish Economic Growth?
A Lloyds bank sign outside a branch in central London. Though a new law requiring 17 percent capital to be held by banks in the UK has not yet passed, Lloyds has announced that it is already in compliance. (CARL COURT/AFP/Getty Images)

Basel 3 to Blame for Sluggish Economic Growth?

April 5, 2013
| Economics
| Europe
Summary
Special Economic Analysis
By Peter Warburton, PhD
 
New financial regulations introduced since 2009 have prompted a shake-up of regulatory organizations and imposed new, more demanding, international banking rules that have put a brake on the pace of economic growth in advanced economies. Central banks and other financial regulators have begun to question the wisdom of their actions, but it may be too late to reverse course.
The strengthening of bank capital requirements and the imposition of new leverage, liquidity and funding rules were intended to instil confidence in the financial system, thereby promoting sustainable growth. The reality, however, is that these rigid frameworks have hurt the economic recovery and prolonged the financial crisis by forcing banks to divert their capital towards compliance, and away from lending.
Background
 
Never underestimate the enthusiasm of politicians to fight yesterday’s war, to lock the stable door after the horse has bolted or to try to ensure that such a terrible financial crisis “never happens again.” Public authorities, criticized for their leniency towards excessive debt accumulation and risk-taking, have engaged in re-regulating the financial system in earnest.
 
In an attempt to remedy the flaws of Basel 2, the pre-existing global bank regulatory standards endorsed by the G20, and prevent future financial crises, the Basel Committee on Banking Supervision developed an additional set of standards, called “Basel 3.” Basel 3 sets out a far more comprehensive approach, in which capital-to-asset ratio requirements have been tightened and new leverage, liquidity and funding rules imposed. Its aim is to strengthen the regulation, supervision and risk management of the global banking sector in order to prevent another financial crisis. 
 
The capital-to-asset ratio is a measure of a bank’s capital (shareholder’s equity, retained earnings and subordinated debt) expressed as a percentage of its risk-weighted assets. Risk weighting ensures that assets considered to be at greater risk of default (such as high loan-to-value mortgages) are backed by more capital as a cushion against potential losses.
 
While total bank capital required under Basel 2 and Basel 3 is nominally the same, at 8 percent of a bank’s risk weighted assets, its decomposition has been redefined. Under Basel 2, Tier 1 capital had to be equal to 4 percent -- of which equity capital had to be at least half. Under Basel 3, a greater proportion of the capital base must be Tier 1 -- meaning that banks should hold no less than 6 percent of their risk weighted assets in common equities, retained earnings and subordinated, non-maturing debt.
 
More specifically, equities and retained earnings should comprise 4.5 percent of this Tier 1 requirement by 2015. Tier 2 capital, which has to be subordinate to deposits and general creditors of the bank -- meaning that it has lower priority in the event of bank insolvency, makes up the remaining 2 percent of the capital base. An additional capital conservation buffer of 2.5 percent is also required under Basel 3, phased in from 2016 to 2019 (figure 1).
 
For banks considered as “systemically important,” of which the Basel Committee estimates there to be 29, a further capital requirement of between 2.5 percent and 3.5 percent will apply. Overall, these banks will be required to hold more than four times the equity capital previously stipulated under Basel 2.

Figure 1
Data source: BIS
 
This capital-to-asset framework is underpinned by a new leverage ratio, aimed at rectifying Basel 2’s oversight which enabled banks to lever-up on highly rated assets while still maintaining capital-to-risk weighted asset ratios. Accordingly, the leverage ratio sets a ceiling on banks exposures (regardless of risk weighting) against Tier 1 capital. By 2015 banks are required to disclose the ratio of their equity to total assets, hitting a minimum ratio of 3 percent in 2018.
 
Another new element of Basel 3 is the Liquidity Coverage Ratio. This has been designed to help ensure that banks have an adequate stock of unencumbered, high quality liquid assets that can be converted into cash easily under short term stress scenarios. A minimum Liquidity Coverage Ratio of 60 percent (measured by a bank’s liquid assets divided by potential net cash outflows over a 30-day period of acute stress) is compulsory by January 2015, rising to 100 percent by January 2019.
 
Unfortunately, many banks have found de-leveraging (reducing their loan assets) to be the most efficient way to meet these heightened capital and leverage ratio requirements. In the UK, which implemented its own minimum liquidity standards in 2009, banks have dramatically increased their holdings of liquid assets (such as high quality government bonds) at the expense of other assets such as small business loans.
 
The overall result is that banks appear to have reduced lending in order to meet these regulatory requirements. This is particularly evident across Europe, where authorities have been more resolute in adopting Basel 3’s recommendations than in the United States, for example.
 
Analysis
 
Taking the example of the UK, policymakers’ eagerness to defend against future financial instability has resulted in even more onerous bank capital and liquidity requirements than those required under Basel 3. Following recommendations from the Vickers report, UK banks’ activities are in the process of being ring-fenced, requiring them to hold even more capital (17 percent) than the 10.5-13 percent stipulated under Basel 3. Although the government’s Banking Bill has not yet passed into law, Lloyds has said that it already has the 17 percent primary loss-absorbing capital in place. 
 
Similarly, although Basel 3 is not meant to be fully implemented until 2019, most banks are aiming to meet the requirements within the next couple of years. In this context, it is hardly surprising that banks aspiring to meet new and stringent capital ratios are making fewer loans – particularly to small and medium-sized enterprises which can require up to five times as much regulatory capital as mortgage lending.
 
In addition to higher capital ratio requirements, the UK’s regulatory authority has also introduced its own liquidity scheme, forcing banks to hold around 50 percent more liquidity than that required by Basel 3. Combined with banks’ desire to drive leverage lower, this has led to reduced lending in other areas.
 
The evidence is persuasive, if not overwhelming, that the Bank of England has stifled normal economic development in the UK through the over-zealous application of financial policy. James Barty, in his recent report titled ‘Capital Requirements: Gold plate or lead weight?’ for the think tank Policy Exchange, wrote:
 
“If austerity has been the cause of the weakness of growth we believe that it is financial austerity, in the form of the Financial Services Authority’s and Bank of England’s attempts to make the banking system safer, more than fiscal austerity that has been to blame.”
 
A recent Financial Services Authority investigation into UK bank balance sheets identified an aggregate £25 billion bank capital shortfall that the Financial Policy Committee says must be bridged by the end of 2013. It was also suggested that even higher capital requirements should be considered for major banks with “concentrated exposures to vulnerable assets….or where banks are highly leveraged relating to trading activities.”
 
This continuous uncertainty surrounding banking regulation, in particular capital-to-asset ratio requirements, is acting as a deterrent to bank lending in the UK, stifling the effectiveness of the Funding for Lending Scheme. Although new lending issued under the scheme does not require additional capital, alternative impositions should be avoided if the scheme is to be a success. After all, why would banks expand their loan books if there is a risk that further punitive regulations are in the pipeline?
 
Figure 2 displays monetary financial institutions’ lending to the UK private sector. On an annual growth rate basis, bank lending has been in decline since mid-2010. 

 
Figure 2
 
Data source: BoE
 
The UK is not alone in its enforcement of additional regulatory requirements over and above international standards. The European Banking authority demanded that all European banks reach a Tier 1 capital to asset ratio of 9 percent by the middle of 2012, far larger than the 6 percent demanded by the Basel 3 framework in 2015. Until then, bank lending across the Euro area had been recovering (figure 3).

 
Figure 3

 Data source: CEIC
 
Norway’s Ministry of Finance has also proposed stricter capital requirements, demanding that banks maintain a common equity Tier 1 capital ratio of more than 9 percent by July 1, 2013, rising to 10 percent from July 2014. Systemically important financial institutions, which the Ministry of Finance has not yet identified, will incur an additional capital requirement of 1 percent in 2015, rising to 2 percent from 2016. The proposal also calls for the imposition of a counter-cyclical buffer (up to 2.5 percent of risk-weighted assets) by July 2014. Sweden has gone even further, proposing a core Tier 1 ratio for its banks of 12 percent by 2015.
 
Similarly, just last month, Canada’s federal budget detailed plans to impose higher capital requirements on banks whose failure could disrupt the Canadian financial system and economy.
 
Switzerland has also applied capital targets earlier than demanded by the Basel 3 framework.
 
Also in March, the Reserve Bank of New Zealand released a consultation paper proposing an increase in banks’ capital requirements for housing loans with high loan- to-value ratios. This will likely discourage New Zealand’s banks from lending to borrowers with smaller mortgage deposits in order to avoid having to source additional capital.
 
Conclusion
 
The combination of national and international banking regulations imposed in response to the financial crisis is undeniably hindering bank lending to individuals and smaller businesses and thereby hurting the economic recovery. Faced by a deluge of new capital, leverage, liquidity and funding requirements, banks have withheld credit even from the most credit-worthy, unencumbered prospective borrowers. 
 
A move towards greater flexibility, as first demonstrated in January when the Basel Committee revised its proposal for the Liquidity Coverage Ratio, is urgently needed. Until then, the much-longed-for economic recovery will remain a hostage to suffocating banking regulation.