One of the lessons from the banking crisis of 2007-2008 is that the minimum capital requirements for banks must be raised. The Accord of the Basel Committee (Basel III) therefore contains agreements on strengthening both the size of the capital buffer and the quality of the loss-bearing equity.
Higher capital requirements will result in a more stable financial system. With more equity, banks will be better able to absorb severe losses. In addition, these higher buffers will make it less likely that banks can fall back on the government to mitigate their losses, which will discourage them from taking irresponsible risks.
For banks with a sound business model, the costs of higher capital requirements will be mitigated by a lower risk premium on their funding costs. A higher capital buffer makes banks more robust and better able to attract cheap capital, enabling them to maintain their level of lending. The reduction of the implicit bail-out guarantees from the government will result in somewhat higher funding costs though, especially for banks that over-rely on these guarantees to raise funding on the cheap. But this is precisely the purpose of these requirements. Investments that depend on government guarantees for their profitability are a risk for financial stability and should be deterred.
Two reasons for higher capital requirements
Governments may feel compelled to rescue a troubled bank given the social costs and possible threat to the stability of the financial system of an outright bank failure. This fact distorts the incentives for risk-taking: positive outcomes benefit banks, whereas the most negative outcomes are absorbed by the government. Another perverse incentive is that banks are stimulated to take advantage of this implicit guarantee by developing financial instruments with large tail risks. Compared to other financial products, a product with a large tail risk bears a relatively smaller likelihood of moderate losses but a relatively higher likelihood of catastrophic losses.
Banks increase their return with these products, at the expense of disproportionately high losses in the exceptional case that the tail risk materialises. Banks do not take sufficient account of the (social) costs of these risks because they will not have to confront them eventually (i.e., they are 'gambling with the government as bankroll'). These forms of financial innovation hence present a risk for financial stability.
Higher capital requirements correct these perverse incentives by shifting more risks to the shareholders. The more capital, the more the risks fall to the shareholders, as the providers of risk-bearing capital, and the smaller the government subsidy for reckless behaviour.
What are the consequences of higher capital requirements on banks’ funding costs?
Under the new international agreements, banks must operate with higher buffers or reduce the risks on their balance sheets. The key question is whether this will result in tighter and more expensive lending.
It is sometimes said that every euro in extra bank capital is one euro less in corporate credit. That is incorrect: equity is not 'idle capital'. Banks will not be forced to reduce their balance sheets. The source of their funding will indeed change as banks must draw more of their funding from equity, but this only influences credit (the use of banks' funds) if this composition also results in higher capital costs.
As equity is more expensive than borrowed funds, one might think that higher capital requirements will automatically result in higher funding costs for banks, so that banks are obliged to charge more for their own lending. However, this effect is (partially) counteracted. Banks with more capital are also more robust, meaning that both equity and borrowed funds will be cheaper when higher capital buffers are imposed. Economic research shows that these effects roughly offset each other for banks that only take measured risks. Banks can therefore keep up lending. It should be noted, however, that banks with more equity partly lose a fiscal advantage because interest payments on borrowed capital are deductible from corporate income tax while dividends are not.
The former does not, however, apply to banks with investments that are only profitable as a result of implicit government guarantees. This typically concerns banks that take on a lot of tail risks. Higher capital buffers make these banks more stable too, but shift the costs of these risks, which were formally born by the government, to the shareholders. This will lead to higher funding costs for these banks, causing the said activities to disappear from the balance sheet. Such a balance sheet contraction is socially desirable, as these investments do not add any economic value: the activities that disappear are only profitable because they can benefit from the free implicit government guarantee.
Higher capital requirements are an essential instrument in strengthening the financial stability of the banking sector. They ensure that banks are in a better position to absorb risks and compel banks to improve their risk control, as they bear the costs of those risks themselves. The result will be that banks will reduce their risks and will price them more effectively. This will strengthen the banking sector. Banks with a healthy business model will be able to keep up their lending.