This report provides an analysis of the long-term economic impact (LEI) of the Basel Committee’s proposed capital and liquidity reforms. It assesses the economic benefits and costs of stronger capital and liquidity regulation in terms of their impact on output. The main benefits of a stronger financial system reflect a lower probability of banking crises and their associated output losses. Another benefit reflects a reduction in the amplitude of fluctuations in output during non-crisis periods. In this analysis, the costs are mainly related to the possibility that higher lending rates lead to a downward adjustment in the level of output while leaving its trend rate of growth unaffected. While empirical estimates of the costs and benefits are subject to uncertainty, the analysis suggests that in terms of the impact on output there is considerable room to tighten capital and liquidity requirements while still yielding positive net benefits.
In interpreting the findings of the report, two points are worth highlighting.
First, the report focuses on the long-run economic impact. The analysis assumes that banks have completed the transition to the new levels of capital and liquidity. To do this, it compares two steady states, one with and one without the proposed regulatory enhancements. The report does not assess the benefits and costs associated with the transition phase. The Macroeconomic Assessment Group (MAG) considers the macroeconomic costs of this transition, but not its benefits.
Second, the report should not be viewed as indicating a particular calibration level. The Committee’s calibration is also being informed by its top-down assessment of the capital and liquidity frameworks and the results of the Quantitative Impact Study. Moreover, references to capital and liquidity ratios in this report are based on historical data and definitions and thus should not be read as corresponding directly to those proposed by the Basel Committee.
Inevitably, the analysis of the macroeconomic benefits and costs is subject to considerable uncertainty. No single approach can capture all the implications of capital and liquidity regulation for bank behaviour and the economy at large. Thus, the report draws on a variety of methodologies and models. The presentation (including sensitivity analysis and technical annexes) provides a sense of the range of results across methodologies and potential uncertainties associated with the estimates.
The core conclusions are illustrated in the graph below. The graph plots a range of estimates for the net benefits per year from reducing the probability of banking crises through higher capital standards while also meeting the liquidity requirements. The net benefits are measured in terms of the long-run change in the yearly level of output from its pre-reform path, with its trend growth rate unchanged. The origin corresponds to the historical average level of the capital ratio and frequency of banking crises – a proxy for the pre-reform steady state. The range of results shown reflects various estimates of the costs of banking crises, depending on whether costs are estimated as, permanent but moderate – which also corresponds to the median estimate across all comparable studies of such costs (red line) – or only temporary (green line). At the same time, taking a conservative approach, the results assume that institutions pass the added costs arising from strengthened regulations on to borrowers in their entirety while maintaining pre-reform levels for the return on equity, interest costs of liabilities and operating expenses. Thus, the costs of meeting the standards may be close to an upper bound. Continue reading