Regulatory response to the crisis: Basel III – costs and benefits

The global financial crisis and Basel III

The Great Financial Crisis that hit the world in 2007 and the Great Recession that followed in 2009 is considered to be the worst crisis since the Great Crash of 1929 followed by the Great Depression of the 1930s. From the policy perspective the crisis resulted from two policy errors: myopic monetary policy and inadequate regulatory policy which were pursued during the period of the Great Moderation. The lax monetary policy and historically low interest rates contributed to the creation of global imbalances, and prompted banks to search for yield which fuelled excessive credit expansion and consequent property price booms, particularly in the US and the UK. The insufficient financial regulation, along with progressing financial innovation (and moving high risks assets to off-balance sheets), encouraged banks to make risky mortgage loans whilst holding too little capital and not enough liquidity.

Addressing the inadequacy of the regulatory framework has thus been one of the post-crisis policy priorities. The Basel Committee which sets international capital standards for banks, at the end of last year, introduced a set of new regulations, Basel III, aimed to prevent a repeat of the crisis that started in mid-2007. Capital standards concerning both the quantity, as well as the quality of capital were redefined (see table 1), and new liquidity benchmarks were introduced.

Core equity increases to 4.5 per cent of risk weighted assets and with a capital conservation buffer of 2.5 per cent above this, the common equity requirement increases to 7 per cent. The high quality Tier 1 capital is set at 6 per cent with the overall minimum capital ratio remaining at 8 per cent. Basel III introduces a countercyclical capital buffer of up to 2.5 per cent, monitored nationally, to be increased if risks increase, in particular during periods of excessive credit growth or property price bubbles.

Costs: tighter regulation reduces output

The impact of Basel III on output is expected to be relatively limited, although it may vary somewhat across countries depending on the level of capitalisation (with effects being milder in countries where capitalisation is already high). NIESR simulations show that a gradual rise - spread over 2011-2016 - to the new capital target by the UK banks would result in a fall in GDP by 1 per cent, and this result is similar to those produced by the BIS using a range of models for various countries. The impact of the new regulation on both the banking sector, and the economy as a whole will also depend on how quickly banks’ balance sheets are adjusted (the quicker the implementation of the new regulations, the greater the impact on output), and this may depend on the speed of recovery in individual countries. The new regulations are expected to be implemented by 2019 and such a relatively long time span will give banks the possibility to use retained profits earned during boom periods of the business cycle, which should minimise the adverse impact of higher capital requirements on the economy.

Calibration of the Capital Framework
Capital requirements and buffers (all numbers in per cent)
Common equity (after deductions)Tier 1 capitalTotal capital
Conservation buffer2.5
Minimum + conservation buffer7.08.510.5
Countercyclical buffer range0-2.5

Benefits: tighter regulation reduces bank risk taking and lowers probability of a crisis

Basel III not only increases capital adequacy ratios, but it also changes the composition of

capital, requiring banks to hold relatively less Tier 2 capital (lower quality capital, mainly subordinated debt) and more Tier 1 capital (high quality capital, mainly equity). Our recent research on a micro level shows that an increase in the overall capital adequacy ratio reduces the risk appetite of banks in both ex-ante and ex-post terms (approximated by loan loss provisions and net charge offs). We also show that banks with higher proportions of Tier 2 have higher charge offs and higher provisions, that is, increasing the proportion of Tier 2 within a given capital adequacy structure increases both ex-ante and ex-post risk measures for banks in OECD countries. This underlines the poor qualities of Tier 2 in terms of possible adverse incentives it may generate and, from the policy perspective, would imply that Tier 2 should be eliminated rather than reduced.

By reducing risks for individual banks, tighter regulation lowers probabilities of banking crises which may be very costly. The average effect of a banking crisis on the sustainable level of output amounts to about 2.5 per cent of GDP, and if the crisis is systemic (as the recent sub-prime crisis) then it is close to 4 per cent of GDP. Recent research at a macro level shows that regulatory factors such as capital and liquidity ratios – together with rising house prices, and current account deficit are the main crisis predictors in OECD countries (and these variables are preferred for the OECD to the traditional crisis variables such as credit growth, monetary policy indicators, inflation, government deficits that perform well for emerging markets). Tighter regulation has thus a marked effect on crisis probabilities, implying long run benefits to offset costs that such regulation may impose in the short run.

To recap, tighter regulation brings costs in terms of a reduction in output and benefits in terms of reduced bank risk taking and lower probabilities of crises. Risks for individual banks, as well as the economy as a whole are significantly reduced, while output costs remain very limited.

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