ChainWhat it assumes · how to break it
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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 must fund more of their lending with shareholders' equity, which costs more than borrowing, and hold more low-return liquid assets.
capital requirements · liquidity ratio
capital requirements · liquidity ratio
Assumes: Equity is more costly to banks than debt.
But: Investors in safer banks with more equity accept a lower return on their shares, which offsets much of the extra cost.
2
This means banks raise interest rates on loans or lend less, especially to riskier borrowers such as small firms.
cost of credit · credit rationing
cost of credit · credit rationing
Best link to attack
Assumes: Banks pass the extra cost on through higher loan rates or less lending.
Assumes: Banks pass the extra cost on through higher loan rates or less lending.
But: Banks can meet the requirement by retaining profits and issuing shares over several years, so lending need not fall.
3
Consequently, investment by firms that depend on bank credit falls, reducing AD and growth in the short run.
investment · AD
investment · AD
Assumes: Firms have no other source of finance.
But: Larger firms can borrow through bond markets, and other lenders may step in.
4
At the same time, the banking system can absorb larger losses, so banking crises become less likely and less severe.
financial stability · systemic risk
financial stability · systemic risk
Assumes: Risk stays inside the regulated banking system.
But: Risky lending can move to less regulated shadow banks outside the capital rules.
5
Therefore, growth may be slightly slower in normal years but more stable over the cycle, since a crisis that cuts GDP sharply is less likely.
economic growth · economic stability
economic growth · economic stability
Assumes: Banking crises cause large and lasting losses of output.
But: If crises are rare, the small cost to growth each year adds up and may outweigh the rare crisis avoided.
End
Growth may be slightly lower in the short run, but more stable over time because damaging banking crises become less likely.
Evaluation chain
- E1However, the effect on lending depends on how banks choose to meet the higher requirement.
- E2If banks are given years to adjust, they can build capital by retaining profits and issuing new shares instead of shrinking their loan books.
- E3As a result, lending and investment fall little, and the main effect is a lower return for bank shareholders.
- E4So the cost to growth is small, and it is outweighed if the rules make a costly banking crisis less likely.
The rules were phased in over several years so that banks could build capital gradually without a sharp cut in lending.
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Questions this answers
- Assess the impact of higher capital requirements for banks on economic growth.
- Evaluate whether tighter regulation of banks is worth the cost.
- Discuss the trade-off between financial stability and economic growth.
Diagram
AD/AS: a small leftward shift in AD from lower investment. No standard diagram shows stability; evidence on the cost of the 2008 recession can show what regulation aims to prevent.
Reverse and related
Lower capital requirements → cheaper credit and faster growth in the short run, with a greater risk of a banking crisis.