ChainWhat it assumes · how to break it
Start
After the 2007–08 crisis, regulators under the Basel III framework required banks to hold more capital and more liquid assets relative to their loans.
1
As a result, banks have a larger cushion of their own capital to absorb losses on bad loans before they become insolvent.
capital requirements · solvency
capital requirements · solvency
Assumes: Losses fall within the size of the cushion.
But: A very large crisis can exhaust even higher capital.
2
This means shareholders bear more of the losses, so banks are less likely to need rescue with public money.
too big to fail · bailout
too big to fail · bailout
Assumes: Governments let shareholders bear losses.
But: If a large bank's failure threatens the whole system, governments may still step in to protect depositors and the payments system.
3
In addition, because owners have more of their own money at risk, they have a stronger incentive to avoid excessive risk-taking, reducing moral hazard.
moral hazard
moral hazard
Best link to attack
Assumes: Higher capital changes the behaviour of those who make lending decisions.
Assumes: Higher capital changes the behaviour of those who make lending decisions.
But: Bank managers rewarded with bonuses on short-term profits may still take large risks, and banks can move into assets the rules treat as low risk.
4
Consequently, the government is less likely to face the bailout costs and deep recession that widened deficits after 2008, so future fiscal balances are stronger.
fiscal balance · public sector debt
fiscal balance · public sector debt
Assumes: Banking crises are a major cause of fiscal deterioration.
But: Other shocks, such as a pandemic or an energy price rise, can widen the deficit whatever the state of the banks.
End
The risk of costly bailouts and crisis-driven deficits falls, protecting the fiscal balance in future.
Evaluation chain
- E1However, how much risk-taking falls depends on whether higher capital changes the incentives of those who make lending decisions.
- E2Because bank managers are often rewarded for short-term profits and can shift into assets the rules treat as low risk, risky lending may continue in other forms.
- E3As a result, the chance of a future crisis and bailout falls by less than the higher capital figures suggest.
- E4So the gain to the fiscal balance is smaller and uncertain, and it depends on regulators such as the Prudential Regulation Authority also supervising how banks measure risk.
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Questions this answers
- Assess the impact of stricter bank regulation on the public finances.
- Evaluate whether higher capital requirements reduce moral hazard in the banking system.
- Discuss how regulation can reduce the risk of future bank bailouts.
Diagram
No standard diagram. Use the cost of the 2008 bank rescues and the rise in UK government debt after 2008 as evidence of what the rules aim to prevent.
Reverse and related
Weaker capital requirements → banks take more risk and future bailouts and deficits become more likely.