Basel 3, the Basel Committee’s new global regulatory standard on banks’ capital adequacy and liquidity, will more or less double the equity requirements, and will impose extra costs on banks deemed “too big to fail.” The Committee’s analysis of the economic consequences found that the impact on growth would be modest, perhaps reducing GDP by 0.33% after five years – easily within the margin of forecast error. The OECD took a different view, putting the growth impact at about twice that level, and rather higher in Europe, where companies rely far more on bank financing than they do in the US.
In sharp contrast, the Institute of International Finance, the leading trade association for the world’s top banks, believes that the impact of higher capital requirements could be far stronger. The IIF believes that GDP could be fully 5% lower after five years, with unemployment more than 7% higher.
The IIF’s forecast may seem alarmist, but the competing estimates are based on some intriguing analytical differences. Regulators take the view that the impact of higher capital requirements on the cost of credit to borrowers will be modest, as the overall cost of funds to banks will not rise much. They rest their case on the famous Modigliani-Miller theorem, which implies that a company cannot alter its capital cost by changing the balance between equity and debt on its balance sheet. If there is more equity, then logically debt should be cheaper, as the company (or bank) is better insulated from default.
Bankers accept that, in the long run, the theorem might hold, but argue that it will take time, especially given recent events, to persuade investors that banks are genuinely safer….
via The Bankers’ Capital War – Howard Davies – Project Syndicate.