Introduction
This article was first published in Quantum magazine.
If you believe the central bankers and regulators from the G20 countries who make up the Basel committee, now in conclave working out the final details of Basel III, it will be a prudent but well-judged package that judiciously balances conflicting objectives.
The committee accepts that its main stipulation—requiring banks to hold higher reserves—will have some economic impact. The cost of credit may be a little higher, so there will be somewhat less investment, and therefore a reduction in economic growth. But it expects that reduction to be less than half a percent over five years.
If, on the other hand, you believe the critics of Basel III, who include some powerful voices in the banks and financial institutions, you may regard a requirement to hold more reserves as a threat to global prosperity.
The Institute of International Finance (IIF), a trade body that represents the world’s largest banks and other financial institutions, argues that banks will struggle to raise the extra capital they need. As a result, credit offered by banks will be constrained, and the cost of loans to borrowers will rise.
The more reserves banks have to hold in the form of equity or unremunerated central bank deposits, the more they will have to charge their customers. That increased cost of credit could, in the IIF’s view, be sufficient to knock three full percentage points off global growth in the next five years.
Why are the differences between these two analyses so marked? It is partly because no such change has been imposed before, so there is no past experience to review. Capital in the banking system has gone up and down from time to time, but never before has there been an increase of this scale over a short period.
There are also some genuine uncertainties about the impact. Financial theory—the so-called Modigliani and Miller theorem—states that in the normal way a firm cannot alter the cost of its capital by changing the mix of equity and debt. So, if banks have more reserves and are therefore more resilient and less likely to fail, the cost of their debt should fall as an offset to the increased equity requirement.
Others dispute the validity of this theorem in the present circumstances. One difficulty is tax. Debt interest is deductible, while dividends on common equity are not. Altering that asymmetry might do more than anything else to strengthen the stability of the financial system.
Also, the impact on the cost of capital depends on the behavior of investors. Will they be prepared to accept lower returns from banks on the basis that those banks are safer? Again, theory suggests that, over time, expectations of the yields on bank stocks should change. But that may not happen quickly. So it will take years to discover whether the Basel committee or the IIF’s analysis is closer to the truth.
Whatever the outcome for economic growth, Basel III seems very likely to go ahead. The political mood is strongly in favor of strengthening bank reserves as politicians strive to avoid any future calls on taxpayers to rescue the financial system. The IIF has not been successful in preventing the large increase in capital requirements, though I suppose it could have been worse.
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