Will Basel III Help or Hurt?

Despite agreement among policy experts that improving global banking regulation is necessary to reduce systemic risk, the most recent attempt to implement such regulation, Basel III, has attracted its fair share of criticism. In a recent study, Thomas Cosimano and Dalia Hakura analyze one of Basel III’s central regulations – increased bank capital requirements on loan volumes and rates – and conclude that higher equity-to-debt ratios are likely to increase lending costs, even if the full effects of the regulation remain to be seen.

Basel III is the product of the annual meeting of the Basel Committee on Banking Supervision (BCBS), which comprises the Central Bank Governors of the 10 major industrialized nations. Since the financial crisis, the BCBS has met in an effort to reduce systemic risk by developing and reforming rules on global standards in banking.  The rules, which are collectively known as Basel III and which will be implemented on a gradual basis until 2019, place restrictions on a bank’s leverage ratio and capital buffers.

The regulations require banks to increase their capital ratios in an effort to protect the financial system during downturns. Capital reserve requirements help mitigate the moral hazard problems created by FDIC’s deposit insurance and when the Federal Reserve acts as lender of last resort. In addition, such requirements help avoid problems that result from information asymmetry between bank managers and depositors.  Without regulation, banks maintain capital ratios which are optimal for each individually, but which may be inadequate from a socially optimal standpoint. When regulators can assess a bank’s capital soundness, in contrast, banks must maintain a capital position better-aligned with financial stability.

In their study of banks from 2001 to 2009, Cosimano and Hakura rely on a core principal of the academic finance literature, the Modigliani–Miller Theorem (MMT), and argue that the higher equity-to-debt ratios required by Basel III will likely increase borrowing costs for banks. This is because banks can raise money in two ways: by borrowing it (issuing debt) or by selling the rights to their future profits (issuing equity). According to the MMT, under ideal conditions an increase in the proportion of equity (which is historically more expensive than debt) should be offset by a decline in the cost of debt due to lower risks of insolvency.

However, empirical results contradict the MMT and find that it is exorbitantly expensive for a bank to raise funds through higher levels of equity compared to debt.  Since banks need to use one method or the other to lend money, the Basel III regulations threaten to dramatically increase the cost of lending money. For example, Cosimano and Hakura find that a 1.3% increase in the required equity-to-debt ratio will increase loan rates by 16 basis points (.16%) across the world’s 100 largest banks.

Basel III advocates argue that such a cost increase is reasonable, especially given the social costs incurred during the recent financial crisis as a result of deregulation. Regardless of the benefits of Basel III, policymakers should be aware that compliance remains an equally serious issue.

According to the study, a 1.3% increase in the equity-to-debt ratio resulted in an expected reduction of loans ranging from 4.6% in countries experiencing the crisis (for example, the U.S. and U.K.) to 14.8% in countries not directly experiencing the crisis (for example, Denmark).  The underlying factor behind the variance is not completely clear. However, the reduction in loans is an indication that it may be difficult for some member countries to comply with such rules when the rules do not appear to benefit them.

Skeptics of Basel III also point out that past efforts to increase equity requirements through Basel II led to the creation of the “shadow banking sector.”  The regulations incentivize banks to utilize opaque procedures, such as shifting assets “off balance sheet.”  Thus, Basel III’s success depends on each nation’s scrutiny of its informal banking sector.

While Basel III can reduce systemic risk, empirical studies like this one raise serious concerns about possible adverse consequences on lending in developed economies and on the global recovery from the 2008 crisis.