Basel Committee on Banking Supervision. An assessment of the long-term economic impact of stronger capital and liquidity requirements

Transcription

1 Basel Commiee on Banking Supervision An assessmen of he long-erm economic impac of sronger capial and liquidiy requiremens Augus 2010

2

3 Copies of publicaions are available from: Bank for Inernaional Selemens Communicaions CH-4002 Basel, Swizerland Fax: and This publicaion is available on he BIS websie ( Bank for Inernaional Selemens All righs reserved. Brief excerps may be reproduced or ranslaed provided he source is cied. ISBN (prin) ISBN (online)

4

5 Conens Execuive summary...1 I. Inroducion...7 II. Economic benefis...8 II.A Benefis from reduced coss associaed wih banking crises...8 II.A.1 The frequency of banking crises...8 II.A.2 The economic coss of banking crises...9 II.A.3 The expeced benefis from reducing he frequency of banking crises...12 II.A.4 The impac of capial and liquidiy requiremens on he probabiliy of crises...14 II.A.5. The impac of capial and liquidiy requiremens on he severiy of crises...17 II.B. Economic benefis from reducing he volailiy of oupu...18 III. Economic coss...20 III.A. Changes in lending spreads...21 III.A.1 The impac of higher capial requiremens...21 III.A.2 Calculaing he impac of higher liquidiy requiremens...23 III.B. Impac on he long-erm seady-sae level of oupu...25 IV. Ne benefis...28 Annex 1: Coss of crises: a lieraure survey...32 Annex 2: A brief summary of he crisis predicion/simulaion models...41 Annex 3: Mapping higher capial and liquidiy requiremens o lending spreads...47 Annex 4: Descripion of he models used o assess he long-erm cos of he new regulaory framework...53 Annex 5: Translaing TCE/RWA ino differen bank capial raios and modelling he link beween he NSFR and banking crises...56 Annex 6: Impac of igher regulaory consrains on consumpion...59 References...60 Working group members...63 An assessmen of he long-erm economic impac of he new regulaory framework

6

7 An assessmen of he long-erm economic impac of sronger capial and liquidiy requiremens Execuive summary This repor provides an analysis of he long-erm economic impac (LEI) of he Basel Commiee s proposed capial and liquidiy reforms. 1 I assesses he economic benefis and coss of sronger capial and liquidiy regulaion in erms of heir impac on oupu. The main benefis of a sronger financial sysem reflec a lower probabiliy of banking crises and heir associaed oupu losses. Anoher benefi reflecs a reducion in he ampliude of flucuaions in oupu during non-crisis periods. In his analysis, he coss are mainly relaed o he possibiliy ha higher lending raes lead o a downward adjusmen in he level of oupu while leaving is rend rae of growh unaffeced. While empirical esimaes of he coss and benefis are subjec o uncerainy, he analysis suggess ha in erms of he impac on oupu here is considerable room o ighen capial and liquidiy requiremens while sill yielding posiive ne benefis. In inerpreing he findings of he repor, wo poins are worh highlighing. Firs, he repor focuses on he long-run economic impac. The analysis assumes ha banks have compleed he ransiion o he new levels of capial and liquidiy. To do his, i compares wo seady saes, one wih and one wihou he proposed regulaory enhancemens. The repor does no assess he benefis and coss associaed wih he ransiion phase. The Macroeconomic Assessmen Group (MAG) considers he macroeconomic coss of his ransiion, bu no is benefis. 2 Second, he repor should no be viewed as indicaing a paricular calibraion level. The Commiee s calibraion is also being informed by is op-down assessmen of he capial and liquidiy frameworks and he resuls of he Quaniaive Impac Sudy. Moreover, references o capial and liquidiy raios in his repor are based on hisorical daa and definiions and hus should no be read as corresponding direcly o hose proposed by he Basel Commiee. 3 Ineviably, he analysis of he macroeconomic benefis and coss is subjec o considerable uncerainy. No single approach can capure all he implicaions of capial and liquidiy regulaion for bank behaviour and he economy a large. Thus, he repor draws on a variey of mehodologies and models. The presenaion (including sensiiviy analysis and echnical annexes) provides a sense of he range of resuls across mehodologies and poenial uncerainies associaed wih he esimaes This repor was produced by he Basel Commiee s Long-erm Economic Impac (LEI) working group, chaired by Claudio Borio (BIS) and Thomas Hueras (UK FSA). The MAG repor is available a hp:// Throughou his repor, capial is defined as angible common equiy (TCE) and he capial raio as he raio of TCE o risk-weighed asses (RWA). TCE is ne of goodwill and inangibles. RWA are measured using hisorical definiions under Basel I and Basel II. The analysis applies o oal TCE held, so ha i does no disinguish beween he minimum capial requiremen and addiional capial ha banks may hold in excess of he minimum requiremen. The assessmen of he liquidiy regulaions focuses on he Ne Sable Funding Raio (NSFR), as defined in he December 2009 proposal. A he same ime, i also provides informaion perinen o he assessmen of he Liquidiy Coverage Raio (LCR). An assessmen of he long-erm economic impac of he new regulaory framework 1

8 The core conclusions are illusraed in he graph below. The graph plos a range of esimaes for he ne benefis per year from reducing he probabiliy of banking crises hrough higher capial sandards while also meeing he liquidiy requiremens. The ne benefis are measured in erms of he long-run change in he yearly level of oupu from is pre-reform pah, wih is rend growh rae unchanged. The origin corresponds o he hisorical average level of he capial raio and frequency of banking crises a proxy for he pre-reform seady sae. The range of resuls shown reflecs various esimaes of he coss of banking crises, depending on wheher coss are esimaed as, permanen bu moderae which also corresponds o he median esimae across all comparable sudies of such coss (red line) or only emporary (green line). A he same ime, aking a conservaive approach, he resuls assume ha insiuions pass he added coss arising from srenghened regulaions on o borrowers in heir enirey while mainaining pre-reform levels for he reurn on equiy, ineres coss of liabiliies and operaing expenses. Thus, he coss of meeing he sandards may be close o an upper bound. Summary graph Long-run expeced annual ne economic benefis of increases in capial and liquidiy Ne benefis (verical axis) are measured by he percenage impac on he level of oupu Increasing capial and meeing liquidiy requiremens 2.5 Capial only Moderae permanen effecs No permanen effecs % 9% 10% 11% 12% 13% 14% 15% 16% Capial raio 0.5 8% 9% 10% 11% 12% 13% 14% 15% 16% Capial raio 0.5 The capial raio is defined as TCE over RWA. The origin corresponds o he pre-reform seady sae, approximaed by hisorical averages for oal capial raios (7%) and he average probabiliy of banking crises. Ne benefis are measured by he difference beween expeced benefis and expeced coss. Expeced benefis equal he reducion in he probabiliy of crises imes he corresponding oupu losses. The red and green lines refer o differen esimaes of ne benefis, assuming ha he effecs of crises on oupu are permanen bu moderae (which also corresponds o he median esimae across all comparable sudies) or only ransiory. The core message of he graph is ha ne benefis remain posiive for a broad range of capial raios, wih he incremenal ne benefis from reducing he probabiliy of banking crises gradually declining o become negaive beyond a cerain range. Admiedly, he precise mapping beween higher capial levels and sricer liquidiy sandards, on he one hand, and he reducion in he probabiliy of crises, on he oher, is quie uncerain. Wih his cavea, he sizeable gap beween benefis and coss for a broad range of assumpions sill suggess ha in erms of he impac on oupu here is considerable room o ighen capial and liquidiy requiremens while sill achieving posiive ne benefis. The following presens in more deail he esimaion mehods, main resuls and broader se of facors ha need o be considered when making an overall assessmen. The body of he repor provides deailed informaion on he dispersion of resuls and uncerainy surrounding hem. 2 An assessmen of he long-erm economic impac of he new regulaory framework

9 Economic benefis The firs sep o esimae he long-erm ne benefis of he regulaory reforms shown in he graph involves calculaing he expeced yearly oupu gain associaed wih he reducion in he frequency and severiy of banking crises. This is equivalen o he reducion in he probabiliy of banking crises imes he discouned oupu coss of heir muli-year effecs he expeced coss of crises. Thus, he calculaion involves wo seps: esimaing he expeced discouned cos of crises and esimaing he impac of sronger capial and liquidiy requiremens on hose expeced coss on he probabiliy and severiy of crises. Hisorical experience suggess ha, in any given counry, banking crises occur on average once every 20 o 25 years, ie he average annual probabiliy of a crisis is of he order of 4 o 5%. The evidence indicaes ha banking crises are associaed wih large losses in oupu relaive o rend and ha hese coss exend well beyond he year in which he crisis erups. The cumulaive (discouned) oupu losses range from a minimum of 20% o well in excess of 100% of pre-crisis oupu, depending primarily on how long-lasing he effecs are esimaed o be. Using he median esimae of he cumulaive discouned coss of crises across all comparable sudies, which is around 60%, each 1 percenage poin reducion in he annual probabiliy of a crisis yields an expeced benefi per year equal o 0.6% of oupu when banking crises are allowed o have a permanen effec on real aciviy. Using he median esimae of losses when crises are seen o have only a emporary effec, which is around 20%, each 1 percenage poin reducion in he annual probabiliy of a crisis yields an expeced benefi per year equal o 0.2% of oupu. 4 While individual counry experiences obviously vary, on balance he frequency of crises does no differ much beween indusrial and emerging-marke economies and, if anyhing, coss appear somewha higher in indusrial economies. Mapping igher capial and liquidiy requiremens ino reducions in he probabiliy of crises is paricularly difficul. This sudy relies mainly on wo ypes of mehodology. The firs involves reduced-form economeric sudies. These esimae he hisorical link beween he capial and liquidiy raios of banking sysems and subsequen banking crises, conrolling for he influence of oher facors. The second involves reaing he banking sysem as a porfolio of securiies. Based on esimaes of he volailiy in he value of bank asses, of he probabiliies and of correlaions of defaul and on assumpions abou he link beween capial and defaul, i is hen possible o derive he probabiliy of a banking crisis for differen levels of capial raios. Combinaions of hese mehodologies are also used. Alhough here is considerable uncerainy abou he exac magniude of he effec, he evidence suggess ha higher capial and liquidiy requiremens can significanly reduce he probabiliy of banking crises. As one would expec, he incremenal benefis decline a he margin. Thus, hey are relaively larger when increasing bank capial raios from lower levels and hey decline as sandards are progressively ighened. As an illusraion, he models sugges ha he decrease in he likelihood of crises is hree imes larger when capial is increased from 7% o 8% han when i is raised from 10% o 11%. Inuiively, he furher away banks are from insolvency, he lower is he marginal benefi of addiional proecion. I should be recognised, hough, ha while he resuls are consisen across mehodologies, he rae a which hese benefis accrue is dependen on model assumpions and is very hard o pin down wih confidence. 4 The average peak-o-rough esimae of losses associaed wih banking crises is around 10%. This ignores he duraion of crises and is hus no comparable o esimaes of cumulaive losses (see Annex 1). An assessmen of he long-erm economic impac of he new regulaory framework 3

10 Inuiively, a sronger banking sysem should also be expeced o reduce he severiy of banking crises. Higher aggregae levels of capial and liquidiy should help insulae sronger banks from he srains faced by weaker ones. There is, however, no exan research on his issue. The preliminary exploraion carried ou in his sudy, based on a simple reduced-form relaionship akin o hose used o esimae he impac on he probabiliy of crises, finds some evidence of a relaionship. However, he esimaed relaionship is saisically weak, perhaps owing o he limied number of observaions ha could be used (10 crises only). In he spiri of conservaism, he esimaes are no used in he calculaion of ne benefis, effecively assuming ha ougher sandards have no impac on he severiy of crises. Economic coss The long-run coss of higher capial and liquidiy requiremens on oupu are assessed using a variey of macroeconomic models, including a subse of hose used by he MAG. 5 The lis includes dynamic srucural general equilibrium (DSGE) models, semi-srucural models and reduced-form models. In conras o he MAG, because of he focus on he long-run seady sae, higher capial and liquidiy requiremens are assumed o increase he cos of bank credi wihou addiional non-price resricions (eg credi raioning). The higher cos of bank credi lowers invesmen and consumpion, in urn influencing he seady-sae level of oupu. The mehodology o calculae he cos depends on he feaures of he macroeconomic models. In hose ha already include measures for capial and/or liquidiy, changes in hese variables can be imposed direcly. In hose ha do no, i is firs necessary o map regulaory requiremens o lending spreads, or he cos of borrowing more generally, as his is always included in he models. The mapping of changes in regulaory requiremens ino lending spreads relies on a represenaive bank s balance shee for several naional banking sysems. The pre-reform seady sae is approximaed by he average composiion of he balance shees over several years prior o he crisis, ogeher wih hisorical esimaes of funding coss and reurns on equiy. Based on his, i is hen possible o calculae he increase in lending spreads necessary o recover he addiional coss of he higher sandards. As already noed, his mapping is based on he conservaive assumpion ha he whole adjusmen is absorbed by lending raes, ie any increase in funding coss or reducions in reurns on invesmens are fully passed hrough. I also assumes ha he cos of capial does no fall as banks become less risky. I hus represens somehing closer o an upper bound. This simple mapping yields wo key resuls, wih he cenral endency across counries measured by he median esimae. Firs, each 1 percenage poin increase in he capial raio raises loan spreads by 13 basis poins. Second, he addiional cos of meeing he liquidiy sandard amouns o around 25 basis poins in lending spreads when risk-weighed asses (RWA) are lef unchanged; however, i drops o 14 basis poins or less afer aking accoun of he fall in RWA and he corresponding lower regulaory capial needs associaed wih he higher holdings of low-risk asses. No surprisingly, hese resuls are sensiive o he reurn on equiy (ROE) ha banks are assumed o arge. For example, if he average ROE is assumed o be 10% (raher han he average of nearly 15% bu consisen wih a range of academic sudies), hen 5 A number of he models used by he MAG could no be employed because hey do no have a well defined seady sae for he level of oupu, or his is difficul o compue. Even so, he resuls produced in his repor are consisen wih hose produced by hose models and he overall MAG resuls, when ha seady sae is approximaed by he level of oupu a he end of he simulaion period used by he MAG (eigh years). 4 An assessmen of he long-erm economic impac of he new regulaory framework

11 each 1 percenage poin increase in he capial raio can be recovered by a 7 basis poin rise in lending spreads. Similarly, he resuls are very sensiive o he full-pass-hrough assumpion. Banks have various opions o adjus o changes in required capial and liquidiy requiremens oher han increasing loan raes, including by reducing ROE, reducing operaing expenses and increasing non-ineres sources of income. Each of hem could cu he coss of meeing he requiremens. For example, on average across counries, a 4% reducion in operaing expenses, or a 2 percenage poin fall in ROE, is sufficien o absorb a 1 percenage poin increase in he capial-o-rwa raio. In pracice, banks are likely o follow a combinaion of sraegies. Based on his inermediae sep, i is hen possible o esimae he impac of ougher regulaory requiremens on oupu across he full se of macroeconomic models. A 1 percenage poin increase in he capial raio ranslaes ino a median 0.09% decline in he level of oupu relaive o he baseline. The median impac of meeing he liquidiy requiremen is of a similar order of magniude, a 0.08%. Comparing benefis and coss overall assessmen The various measures jus described are hen pu ogeher o quanify he ne benefis shown in he summary graph. Tha graph indicaes ha, on balance, here is considerable scope o increase capial and liquidiy sandards while yielding posiive ne benefis. In reaching an overall assessmen, however, i is imporan o highligh he facors ha are no considered explicily in he graph and ha could make he final esimae of he ne benefis higher or lower. Some of hese facors have already been noed. In some cases, quanifying heir effecs is exceedingly difficul. Several facors could lead o a higher esimae of ne benefis: In addiion o reducing he probabiliy of banking crises, higher capial and liquidiy sandards, by making he financial sysem more resilien, can reduce he ampliude of he business cycle. This impac can be enhanced hrough counercyclical capial buffer schemes. While hard o compare wih he benefis included in he graph, hese effecs can be significan. They are evaluaed in deail in secion II.B and Annex 4 of his repor. In a similar way o ha noed above, bu focusing on crisis periods, a risk-averse sociey would be prepared o pay a premium over he expeced coss of an exreme even such as a banking crisis (probabiliy imes is cos in erms of oupu) in order o insure agains i, ie pay over he acuarially fair price. This premium has no been included in he calculaions and would increase he benefis. The expeced coss of crises are based on daa from hisorical episodes feauring large-scale governmen inervenion o minimise he negaive effecs on oupu. In he absence of such inervenion, he average coss of banking crises are likely o be significanly higher. In addiion, he discoun rae used o esimae he presen value of he muli-year cos of crises is quie conservaive. To he exen ha higher capial and liquidiy requiremens also reduce he severiy of crises, he benefis will be higher. The analysis assumes full pass-hrough of he higher funding coss/lower yield from invesmens o loan raes. However, in he long run i is reasonable o expec ha, by reducing banks riskiness, higher capial and liquidiy requiremens should lead o lower deb and equiy coss. Moreover, once adjusmen is complee, differences An assessmen of he long-erm economic impac of he new regulaory framework 5

12 beween he cos of equiy and deb could reduce o ax effecs. Banks could also adjus by increasing efficiency or reducing operaing expenses. These effecs would subsanially reduce he esimaed long-run coss. To he exen ha greaer inermediaion is provided by he non-bank secor, he esimaed coss will be lower. Similarly, here are a number of facors ha could reduce he ne benefis: The exising lieraure, which is he basis for his repor s esimaes of he coss of banking crises, may overesimae he coss of banking crises. Possible reasons include: overesimaion of he underlying growh pah prior o he crises; failure o accoun for he emporarily higher growh during ha phase; and failure o fully conrol for facors oher han a banking crises per se ha may conribue o oupu declines during he crisis and beyond, including a failure o accuraely reflec causal relaionships. Capial and liquidiy requiremens may be less effecive in reducing he probabiliy of banking crises han suggesed by he approaches used in he sudy. This would reduce he overall ne benefis for a given level of he requiremens. However, o he exen ha ne benefis remain posiive, i would also imply ha he requiremens would need o be raised by more in order o achieve a given ne benefi. Shifing of risk ino he non-regulaed secor could reduce he financial sabiliy benefis. The resuls of he impac of regulaory requiremens on lending spreads are based on aggregae balance shees wihin individual counries, so ha hey do no consider he incidence of he requiremens across insiuions. They implicily assume ha he insiuions ha fall shor of he requiremens (ie, ha are consrained) do no reac more han hose wih excess capial or liquidiy (ie, ha are unconsrained). These effecs may no be purely disribuional. As a final cavea, he resuls summarised above reflec he esimaed ne benefis associaed wih higher capial and liquidiy sandards, averaged across a number of counries over an exended period. Clearly, here is a range of uncerainy around esimaes of cenral endencies, reflecing daa limiaions and he need for various modelling assumpions. In addiion, he esimaed ne benefis may be higher or lower in individual cases. 6 An assessmen of he long-erm economic impac of he new regulaory framework

13 I. Inroducion This repor assesses he Long-erm Economic Impac (LEI) of he Basel Commiee s December 2009 proposed reforms o he capial and liquidiy frameworks. Is purpose is o assess he economic benefis and coss of more sringen capial and liquidiy requiremens once banks have compleed he ransiion o he new requiremens. Imporanly, he aim of he repor is no o provide a specific calibraion of he capial and liquidiy requiremens. Raher han gauging he opimal level of capial and liquidiy requiremens, he analysis aims a collecing and synhesising quaniaive evidence regarding he relaive magniude of he macroeconomic benefis and coss. In doing so, i provides a range over which he benefis exceed he coss in he long run. Given he uncerainies involved in he assessmen, his exercise simply helps o ouline he conours for he calibraion exercise. On balance, he analysis suggess ha here is considerable room o ighen capial and liquidiy requiremens while sill yielding posiive ne benefis, measured in erms of oupu. The repor focuses exclusively on he long run, or endpoin of he reforms. I assesses he shif from one seady sae o anoher (wih and wihou he reforms). As such, i does no assess he coss associaed wih he ransiion phase iself. The ask of assessing he coss during he ransiion phase has been underaken by he Macroeconomic Assessmen Group (MAG). 6 In addiion, he MAG measures only coss. I does no consider he benefis ha higher capial provides during he ransiion phase by making he banking sysem sronger. These benefis accrue immediaely. To inerpre correcly he resuls of he repor, he definiion of capial is criical. Capial in his repor refers o oal capial holdings; no disincion is made beween he minimum capial requiremen and addiional buffers. Moreover, capial is defined as angible common equiy (TCE) 7 and he capial raio as he raio of TCE o risk-weighed asses (RWA), where RWA are based on definiions under Basel I and Basel II. The acual values of capial and RWA under he new proposals will herefore differ. 8 In his conex i mus be sressed ha he definiions used were in par dicaed by he availabiliy of daa and, while relaed o regulaory raios, hey should no be read as exacly corresponding o eiher he Basel II raios or he revised raios under consideraion by he Basel Commiee. The analysis of he impac of liquidiy sandards presens paricular challenges. Under he BCBS s December 2009 proposal, banks would be required o mee wo new liquidiy requiremens a shor-erm requiremen called he Liquidiy Coverage Raio (LCR) and a long-erm requiremen called he Ne Sable Funding Raio (NSFR). The LCR ensures ha banks have adequae funding liquidiy o survive one monh of sressed funding condiions. The NSFR addresses he mismaches beween he mauriy of a bank s asses and ha of is liabiliies. The repor focuses mainly on he NSFR, seen as he more relevan consrain for macroeconomic effecs in he long run. In addiion, daa limiaions made i especially hard o The MAG was se up a he reques of he Chairs of he BCBS and he FSB and is a collaboraive effor comprising represenaives from cenral banks and regulaors in 15 counries. The repor of he MAG is available a hp:// Common equiy = common sock + addiional paid-in capial + reained earnings reasury shares; angible common equiy = common equiy inangibles goodwill. Given ha he models used o assess he economic benefis and coss are calibraed o a variey of hisorical capial adequacy measures, he analysis in his repor uses a mapping from hese measures o he raio of TCE o RWA. This convers differen raios ino a consisen variable using saisical echniques (see Annex 5). An assessmen of he long-erm economic impac of he new regulaory framework 7

14 analyse he LCR for naional banking sysems. A he same ime, he use of he raio of liquid asses o oal asses in specific pars of he analysis also provides informaion relevan for he assessmen of he effecs of he LCR. In his repor, references o he liquidiy requiremen refer o he December 2009 proposal for he NSFR. This repor proceeds as follows. Secion II oulines he seady-sae economic benefis of sronger capial and liquidiy requiremens. The benefis reflec mainly a lower incidence of cosly banking crises, bu also a likely reducion in he ampliude of normal business cycles. Secion III provides esimaes of he seady-sae economic coss of increasing capial and liquidiy. Secion IV brings ogeher he analyses of he previous wo secions o arrive a a range of quaniaive esimaes of hose ne benefis. I hen highlighs a se of facors no explicily covered in he ne benefi esimaes and ha should be aken ino accoun when making an overall assessmen. A series of annexes provide greaer deail on he exising research ino crises, on he models and mehodologies used in his paper, and on he esimaion resuls. II. Economic benefis The economic benefis of enhanced capial and liquidiy regulaions reflec mainly he fac ha a more robus banking sysem would be less prone o crises ha have large macroeconomic effecs in erms of forgone oupu. Tigher regulaory sandards may also lead o smaller oupu flucuaions and, hence, higher welfare even in he absence of banking crises. This secion synhesises he evidence on hese wo effecs. I firs reviews he lieraure on he coss of banking crises and presens evidence on he impac of capial and liquidiy regulaion on he probabiliy of sysemic banking crises and on heir severiy. I hen proceeds o discuss he evidence on he poenial effec of igher sandards on he cyclical volailiy of GDP. The primary findings are: (i) on average, sysemic banking crises have been very cosly, wih longer-erm losses of oupu ha are as high as muliples of annual GDP; (ii) beer capialisaion and higher liquidiy of banks reduce he likelihood of crises; (iii) here is some evidence ha higher capial and liquidiy reduce he severiy of crises; and (iv) he reforms can reduce he ampliude of business cycles, no leas if counercyclical capial buffers are in place. II.A Benefis from reduced coss associaed wih banking crises This repor measures he expeced yearly oupu gain associaed wih he reducion in he frequency and severiy of banking crises as he reducion in he annual probabiliy of banking crises imes heir oupu coss, ie as he reducion in he expeced coss of crises. Linking sronger capial and liquidiy requiremens o he expeced coss of crises requires esimaion of he relaionships of capial and liquidiy raios o he probabiliy and severiy of crises. II.A.1 The frequency of banking crises Averaging across counries and ime, hisorical experience indicaes ha banking crises occur once every 20 o 25 years. The only period free of banking crises is ha from he end of he Second World War unil (depending on he counry) he early 1970s 1980s a period 8 An assessmen of he long-erm economic impac of he new regulaory framework

15 in which he financial secor was very heavily regulaed. 9 Crises have reoccurred and ended o become more frequen since hen. Table A1.4 in Annex 1 provides an overview of he banking crises in BCBS member counries since Differen auhors classify crises differenly. Reinhar and Rogoff (2008) find 34 crises over he 25 year period, while Laeven and Valencia (2008) repor only 24. Taking hese ogeher, i is possible o conclude ha he frequency of crises ranges from 3.6% o 5.2% per year, wih an average across samples and definiions of around 4.5%. 10 Ineresingly, he frequency of crises seems o be, if anyhing, slighly higher for G10 counries. In wha follows, hese average frequencies will be inerpreed as he probabiliy of a banking crisis in any given year and counry. II.A.2 The economic coss of banking crises There is a subsanial body of lieraure esimaing he economic coss of banking crises in erms of GDP forgone. While researchers have adoped a variey of mehods, on average he magniude of he resuling GDP coss is esimaed o be very large. Graph 1 Measuring he coss of crises: a schemaic overview Example 1 Example 2 GDP Trend GDP Trend A D Trend afer crisis A δ C C B B Crisis Time Crisis Time Poin A: pre-crisis peak. Poin B: pos-crisis rough. Poin C: GDP growh equals rend GDP growh for he firs ime afer he crisis. Poin D: he level of GDP reurns o he pre-crisis level. Graph 1 provides an overview of he approaches used in his lieraure o assess he coss. I depics he pah of GDP over he differen phases of wo sylised ypes of banking crisis (examples 1 and 2). In each case, poin A shows he peak of he business cycle prior o he crisis; poin B marks he subsequen urning poin for GDP (he cyclical rough); and poin C shows he poin where he pah of GDP regains is pre-crisis rend growh rae. The difference beween he wo examples is ha in example 1 oupu evenually caches up wih is pre-crisis pah (a he poin labelled D ), while in example 2 GDP remains on a permanenly lower pah, albei one wih he same growh rae as ha prevailing prior o he 9 10 See Reinhar and Rogoff (2008) or Laeven and Valencia (2008). The frequency is calculaed as he number of crises divided by he produc of he number of years from and number of counries in he sample, independen of wheher counries experienced a crisis or no. This essenially assumes ha he lengh of he crisis is one year (see also foonoe 14). An assessmen of he long-erm economic impac of he new regulaory framework 9

16 crisis. In example 2, he permanen loss in he level of GDP arising from he crisis is labelled δ. In oher words, in example 1 he cos of he crisis is emporary, while in example 2 i is permanen. Table 1 applies he classificaion adoped in Graph 1 o he findings in he lieraure. The able summarises he resuls found in he lieraure, he deails of which are provided in Annex 1 and Table A1.1. Since differen sudies rely on differen merics, he resuls are presened along wo dimensions. The rows relae o he ime over which he coss are measured: he period beween peak and rough (beween A and B); he period unil he growh rae recovers o he pre-crisis rend (beween A and C); and he period unil he end of he crisis. 11 The columns relae o how he coss are measured. The lef-hand column compares he level of GDP a he end of he corresponding period wih ha a he beginning of he episode. The righ-hand column shows he cumulaive loss in GDP over he corresponding period. In he case of permanen oupu effecs (las row), he figure in he lefhand column corresponds o he size of he permanen effec (δ) in he level of GDP, and ha in he righ-hand column o he cumulaive (discouned) losses in oupu, boh measured as deviaions from he rend growh pah prevailing before he crisis. Overall, he lieraure poins o subsanial oupu losses. In he firs column of Table 1 he median drop in oupu across crises and across sudies, eiher he peak-o-rough (A o B) or unil growh recovers o is pre-crisis rend (A o C), is 9 10%. Sudies ha found a permanen gap beween he pre- and pos-crisis implied growh pah (δ in Graph 1) esimae his gap o be beween 2 and 10%, wih a median of abou 6%. Table 1 Median oupu losses associaed wih a banking crisis 1 (as a percenage of pre-crisis GDP) Difference beween GDP a beginning and end of Cumulaive discouned loss period Period from peak o rough (A o B) 9 Period unil growh rae recovers (A o C) 10 Period from peak o end of crisis 2 19 Infinie horizon (in he presence of permanen seady-sae effecs) (δ, in example 2) Memo iem: Median cumulaive effec across all 63 sudies 1 Numbers are medians of he resuls repored by a number of academic sudies. See Annex 1 and Table A1.1for deails. As a percenage of pre-crisis GDP. 2 The caegory includes sudies where he endpoin for crises was deermined by he ime when GDP recovered o is pre-crisis peak, by exper judgmen, or by assuming ha crises las a fixed number of years. 3 Sudies assessing he impac of banking crises on long-run oupu find on average a 10% effec. Sudies using poenial oupu (eg based on OECD esimaes) find on average a 2% drop. 11 The erminology used in many sudies does no make a clear disincion beween he lengh of a crisis and ha of is effec on oupu. Sudies deermine he endpoin of crises by exper judgemen, by assuming ha crises las a fixed number of years, or by he ime when GDP recovers o is pre-crisis growh pah (poin D in he graph). When effecs are permanen, using his erminology, crises would in effec have an infinie horizon. 10 An assessmen of he long-erm economic impac of he new regulaory framework

17 Since all sudies show ha, even if emporary, he impac of banking crises lass for several years, cumulaive oupu losses are higher han peak-o-rough (A o B) declines. The median discouned cumulaive loss of oupu over he course of a crisis esimaed wihou allowing for he possibiliy of permanen effecs (he area beween he pre-crisis growh pah and acual oupu beween poins A and D) is 19% of peak pre-crisis GDP (of poin A). Sudies ha do allow for he possibiliy of permanen effecs find hem and esimae he corresponding median cumulaive oupu loss a 158%. The median cumulaive loss across all comparable sudies is 63%. These resuls from he exising lieraure are obviously based on crises prior o he curren one. Haldane (2010) provides a range of esimaes for he banking crisis assuming ha a varying fracion of oupu losses experienced in 2009 will be permanen he fracions are 25%, 50% and 100%. Using hese figures, Haldane esimaes ha global oupu losses are a minimum of 90% of 2009 world GDP, bu could rise o as high as 350% if he whole oupu loss urns ou o be permanen (see Table A1.1). Graph 2 illusraes he findings using some hisorical examples. I shows he evoluion in he level of GDP per capia 10 years before and afer each banking crisis. The various panels reveal a downward shif in rend oupu in he afermah of a crisis a sign of a possible permanen effec. In some cases, even rend growh raes appear o be permanenly lower afer he even. This is consisen wih one sudy ha finds banking crises can have a negaive effec on growh even over a 30-year horizon (Ramirez (2009)). By focusing on medians across models, Table 1 masks a significan range of crisis oucomes across sudies and individual episodes. For example, one sudy found on average discouned cumulaive losses of banking crises ha exceed 300%. Mos sudies also repor ha he maximum cos of an individual episode is hree o five imes higher han he average cos of a crisis (see Table A1.1). Researchers also end o find, if anyhing, ha indusrial counries suffer greaer coss han emerging markes. Ineviably, since crises are rare, saisical precision can only be achieved by pooling counry experiences. This is appropriae o he exen ha he economic processes underlying crises and counry characerisics are relaively similar. I is always possible, however, ha he average inernaional experience is no represenaive of ha of an individual counry. The resuls repored in Table 1 are robus o a variey of cross-checks (see Annex 1). For example, sudies ha specifically allow for he possibiliy of reverse causaliy ie ha banking crises may be caused by, raher han cause, he reducions in oupu also repor sizeable effecs. Moreover, he resuls may underesimae he size of he losses in ha hey do no ake accoun of he effec of governmen inervenion ha ofen akes place o limi he impac of he crisis on oupu. In he absence of such inervenion, he coss of crises could be much higher a view ha is suppored by evidence on he coss of crises back in hisory when governmen inervenion was much smaller. 12 Tha said, i should also be recognised ha facors unrelaed o banking crises, and no well conrolled for in hese sudies, may also influence he oupu losses observed in he daa. 12 Moreover, he discoun rae used o calculae he presen value of fuure losses is raher conservaive (5%). Were a lower discoun rae o be used, he median losses would be higher; see Annex 1. An assessmen of he long-erm economic impac of he new regulaory framework 11

18 Graph 2 Oupu around banking crises Unied Saes 2007 Japan 1992 Unied Kingdom Real GDP per capia 1 Forecas Beginning of crisis Beginning of crisis 2 Beginning of crisis Mexico 1981 Korea 1997 Sweden Beginning of crisis 2 Beginning of crisis 2 Beginning of crisis GDP per capia is he logarihm of real GDP per capia, normalised o 1 a he beginning of he crisis. The saring years for crisis are based on Laeven and Valencia (2008) and Reinhar and Rogoff (2008). Source: IMF (2009). Why should he effecs of banking crises be so long-lasing, and possibly even permanen? One reason is ha banking crises inensify he deph of recessions, leaving deeper scars han ypical recessions. Possible reasons for why banking relaed crises are deeper include: a collapse in confidence; an increase in risk aversion; disrupions in financial inermediaion (credi crunch, misallocaion of credi); indirec effecs associaed wih he impac on fiscal policy (increase in public secor deb and axaion); or a permanen loss of human capial during he slump (radiional hyseresis effecs). To elaborae on his poin, noe ha for oupu effecs o be emporary, in he pos-crisis period here needs o be an inerval of above-rend growh ha will reurn he economy o he pah i would have followed in he absence of he crisis. As long as he channels lised above reduce poenial oupu, here is no reason o expec a period of higher growh o follow afer he adjusmen has aken place. This may also hold in cases where he crisis is accompanied by a reducion in deb and he capial sock from unsusainable levels. During he sock adjusmen phase, oupu growh is slower or negaive unil he excess is reabsorbed, a which poin he economy can reurn o is previous rend growh rae. In such a case, he adjusmen phase is no followed by a period of above average growh, so ha permanen effecs on oupu are observed. II.A.3 The expeced benefis from reducing he frequency of banking crises Based on he repored resuls in his secion, Table 2 shows he expeced annual benefi ha would accrue from reducing he probabiliy of a banking crisis by 1, 2 or 3 percenage poins per year, respecively. The benefi is calculaed as he reducion in he annual probabiliy of a 12 An assessmen of he long-erm economic impac of he new regulaory framework

19 crisis imes he cos of a crisis, measured as he discouned presen value of he cumulaive loss. These benefis depend on he coss of he crisis. The firs column repors he benefis arising under he assumpion ha crises have no permanen effecs he case in which he median cumulaive loss is 19% of pre-crisis GDP ( = 0). The second column repors he benefis assuming he median cos of crises across all comparable approaches repored in he lieraure. 13 This implies a loss equivalen o 63% of pre-crisis GDP and could be hough of as corresponding o a moderae permanen effec on oupu (eg = 3%). The hird column looks a he consequences if he oupu coss of crises are assumed o be equal o he median loss repored by sudies ha allow for permanen effecs (ie 158% of pre-crisis GDP or = 7.5%). However, given he uncerainy associaed wih he esimaes and aking a pruden approach, less emphasis is placed on hese resuls in he analysis ha follows. 14 The able shows ha reducing he probabiliy of crises has subsanial benefis. Even in he absence of any permanen crisis-relaed oupu effecs, a 1 percenage poin reducion in he probabiliy of crises generaes a benefi on he order of 0.2% of GDP per year. When crises have long-lasing effecs, he gains are commensuraely larger, beween 0.6% and 1.6% of GDP per year. Table 2 Expeced annual benefis of reducing he annual probabiliy of crises 1 Reducion in probabiliy of crises (in percenage poins) Crises have no permanen effec on oupu Crises have a long-lasing or small permanen effec on oupu Crises have a large permanen effec on oupu The expeced annual benefis are measured as he reducion in he annual probabiliy of a crisis imes he (discouned) cumulaive oupu losses due o a banking crisis. Cumulaive oupu losses are 19% (no permanen effec), 63% (small permanen or long-lasing) and 158% (large permanen). All he figures are in percenages of long-run GDP per year. The resuls in Table 2 are simply he produc of he change in he annual probabiliy of a crisis and he cos if he crisis occurs. Pu differenly, hese esimaes do no depend on how he reducion in he likelihood of a crisis is achieved. The nex secion links he igher regulaory sandards o he change in he probabiliy of a banking crisis This has o exclude he sudies ha measure oupu losses only as he peak-o-rough fall in GDP, as hey do no ake ino accoun he lengh of he crises (cumulaive losses). The high-side esimaes are based on sudies ha exrapolae a significan porion of he observed pos-crisis shorfall in oupu ino he indefinie fuure. However, he longer lasing he reducion in oupu, he greaer he chance ha i could reflec oher facors, such as a persisen slowdown in rend produciviy growh ha occurred independenly of he financial crisis; in fac, such facors may be an underlying cause of he financial crisis iself. Given his risk, i seems pruden o ake a conservaive approach and focus on he wo lower ses of esimaes in his analysis. An assessmen of he long-erm economic impac of he new regulaory framework 13

20 II.A.4 The impac of capial and liquidiy requiremens on he probabiliy of crises The repor uses hree differen mehods o esimae he relaionship beween regulaory requiremens and he probabiliy of a crisis occurring in a given year: reduced-form models, calibraed porfolio models and calibraed sress es models. The resuls poin o a clear role for capial. Liquidiy is also imporan, bu because i presens more daa and modelling challenges han capial is impac is addressed by fewer models and resuls vary more across models. The res of his secion oulines he mehodologies followed and presens he main resuls. Annex 2 provides a more deailed descripion of he models and he individual resuls. 15 Mehodologies Reduced-form models esimae he probabiliy of crises based on he saisical relaionship beween he incidence of crisis episodes and aggregae daa on banks leverage and liquidiy, as well as oher variables ha serve as conrols. The repor used resuls from hree such models examining he experience of a panel of counries over a period of nearly 30 years ( ). 16 These models incorporae he impac of liquidiy on he probabiliy of crises, albei in he form of he raio of liquid asses o oal asses raher han he raios specified in he December 2009 proposals of he Basel Commiee. Two models also makes a disincion beween liquidiy on he asse and liabiliy (funding) sides of he balance shee, by inroducing he raio of deposis o oal liabiliies as an addiional variable. Porfolio models employ sandard porfolio credi risk mehodologies o quanify he impac of higher regulaory requiremens on he probabiliy of sysemic crises by reaing he sysem as a porfolio of banks each bank being he analogue of a securiy in a porfolio. One model uses daa for five UK banks, including informaion on counerpary credi risk in he inerbank marke. The oher model analyses a sysem of more han 50 large global banks. Boh models use informaion from marke prices as key inpu parameers, such as defaul correlaions, in deriving he likelihood of a sysemic crisis. Given heir srucure, however, neiher of hese models can assess he impac of liquidiy requiremens. Wih his in mind, he model esimaed on he sample of global banks was augmened by a reduced-form relaionship beween he probabiliy of defaul of he banks in he porfolio and heir capial and liquidiy raios in order o produce anoher se of resuls ha is also applicable o liquidiy raios. The final approach used in his exercise relies on he Bank of Canada s sress esing framework. This mehodology is based on he idea ha he failure of a bank arises from eiher a macroeconomic shock or spillover effecs from oher disressed banks. Spillover effecs arise eiher because of counerpary exposures in he inerbank marke or because of asse fire sales ha affec he mark o marke value of banks porfolios. In his conex, a greaer buffer of liquid asses can only be beneficial insofar as i helps he bank o avoid asse fire sales, which would oherwise lead o losses. The resilience of he sysem is measured in erms of is response o very severe macroeconomic shocks. Resuls Table 3 summarises he core resuls. These are repored as he average probabiliies of a crisis implied by he various models for differen levels of capialisaion. The wo righ-hand Annex 2 also repors poin esimaes of he probabiliy of a sysemic banking crisis, which correspond o various capial raios and, where appropriae, liquidiy buffers for he individual modelling approaches. One model was esimaed by he UK FSA/NIESR, and he oher wo by he Bank of Japan (see Annex 2). 14 An assessmen of he long-erm economic impac of he new regulaory framework

21 columns of he able also repor he impac of meeing differen levels of srenghened liquidiy sandards using he subse of models ha can analyse he impac of liquidiy. The inerpreaion of he resuls is subjec o wo caveas, which highligh he uncerainy surrounding he findings. Firs, as wih all economeric exercises, many esimaes repored here are based on hisorical correlaions beween capial and liquidiy levels, on he one hand, and he occurrence of crises, on he oher. These backward-looking correlaions may no accuraely represen fuure relaionships or causal links. Tha said, he more srucural calibraed porfolio models should be more robus o his criique, hough hese models also rely upon assumpions regarding long-run relaionships among variables. Second, he models used in his conex rely more han oher pars of he analysis on capialisaion and liquidiy raios ha are differen from he sandard ones used across he repor. 17 Hence, he inerpreaion of he resuls requires as an inermediae sep a mapping of he relevan regulaory variables ino hose used in he models. 18 The need o make hese conversions using saisical esimaes inroduces addiional uncerainy abou he esimaes, which is more pronounced in he case of he liquidiy raios. In his conex i should be noed ha acual levels held by banks ypically include buffers above he minimum. Table 3 The impac of capial and liquidiy on he probabiliy of sysemic banking crises (In percen) All models Models unable o assess changes in liquid asses Models incorporaing changes in liquid asses TCE/RWA No change in liquid asses No change in liquid asses No change in liquid asses Meeing NSFR (NSFR = 1) 1 NSFR = # models Meeing he NSFR is modelled as a 12.5% increase in he raio of liquid asses over oal asses. 2 The NSFR equals 1.12 if liquid asses increase by 50% for he average bank Nearly all of he resuls repored below are based on models calibraed o he raio of oal capial o oal asses raher han o ha of TCE o RWA. Similarly, due o he lack of daa, he analysis of he impac of higher liquidiy was firs conduced in erms of he raio of liquid asses o oal asses and hen convered (approximaely) o he raios in he BCBS December 2009 proposals. Annex 5 describes he mapping procedure. An assessmen of he long-erm economic impac of he new regulaory framework 15

22 A consisen resul across differen models and mehodologies is a significan reducion in he likelihood of a banking crisis a higher levels of capialisaion and liquidiy for he banking sysem as a whole. This is rue boh for he models ha focus only on capial (summary shown in hird column from he lef) and hose ha incorporae liquidiy effecs (summary shown in he fourh column). A TCE/RWA capial raio of 7% is roughly equivalen o he average capial o oal asse raio of 5% and is associaed wih a probabiliy of a sysemic crisis of 4.6%, which is roughly equal o he hisorical average experience. 19 As a resul, one can hink of he corresponding row and he columns ha do no consider any increase in he liquidiy raio as reflecing he pre-reform seady sae. Increasing he capial raio from 7% o 8%, wih no change in liquid asses, reduces he probabiliy of a banking crisis by one hird (eg from 4.6% o 3.0%). Looking a he models ha incorporae changes in liquid asses, increasing he liquidiy raio o mee he NSFR while keeping a capial raio of 7% reduces he likelihood of sysemic banking crises from 4.1% o 3.3%. The reducion in he probabiliy of crises coninues as capial and liquidiy levels increase, as can be seen by comparing figures down he rows (for capial) and across he hree columns on he righ-hand side (for liquidiy). In fac, if he liquid asses o oal asses raio exceeds he proposed liquiidy requiremen, a a 7% TCE/RWA raio, he esimaed reducion in he probabiliy of crises is abou he same as ha associaed wih an increase of 2 percenage poins in he capial raio (from 7% o 9%). Anoher consisen resul across models is ha he incremenal benefi of higher capial and liquidiy requiremens declines as he sysem becomes beer capialised. Tha is, when banks have low levels of capial, even small increases have a very significan impac, bu he marginal benefi of furher increases in capial raios declines as banks move furher away from he insolvency hreshold. For insance, increasing capialisaion from 10% o 11% induces a drop in he likelihood of crises abou one quarer o one hird of he corresponding esimaed drop when TCE/RWA increased from 7% o 8%. Similarly, he incremenal fall in crisis probabiliies from a ighening of liquidiy sandards declines as he levels of capial increase. These resuls are fairly inuiive. The raionale is quie similar o ha applying in he conex of risk models applied o individual banks. For a given volailiy in he value of asses, he furher away a bank is from he insolvency hreshold, he lower is he benefi of addiional proecion. This declining marginal conribuion of capial and liquidiy in reducing he probabiliy of crises has wo imporan implicaions. Firs, he benefis of igher sandards are no wihou bounds bu hey plaeau a some poin. Second, he benefis will depend no only on he iniial condiions for capial and liquidiy, bu also on he oher condiioning variables used o calibrae hese models. As menioned earlier, hese resuls on he impac of igher regulaory sandards on he probabiliy of crises are subjec o considerable model and esimaion uncerainy. Despie he fac ha he message from differen models is quie consisen, here is a possibiliy ha he effec could be differen from ha esimaed. One possibiliy is ha he decline in he probabiliy of crises is more gradual han suggesed by Table 4 and Annex 2. If so, he rae a which benefis of igher regulaory sandards accrue would be lower han repored. This could arise, for insance, if banks responded in par o he imposiion of sandards by seeking o increase he risks hey ake on (eg, increase he volailiy of heir asses) in undeeced ways. However, o he exen ha ne benefis remain posiive, in order o achieve a comparable level of benefis, sandards would have o be ighened furher han implied by 19 The average raio of oal capial and reserves o oal asses for he 14 larges OECD counries from 1980 o 2007 is 5.3%. Using an average of he conversion ables presened in Annex 5, a TCE/RWA raio of 7% is equivalen o a 5% raio of oal shareholder equiy over oal asses. 16 An assessmen of he long-erm economic impac of he new regulaory framework