The Bankers’ Capital War – Howard Davies – Project Syndicate

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.

Fed’s Kocherlakota on Why Balance Sheet Expansion Need Not Be Inflationary – Real Time Economics – WSJ

I’ve mentioned how the Federal Reserve has bought over $2 trillion of government securities. It has funded that purchase by tripling the amount of deposits held by banks with the Fed — what are called bank reserves.

……. Banks have few good lending opportunities, and so they’re not trying to attract deposits. As a result, they are keeping nearly $1.6 trillion of reserves at the Fed in excess of what they need to back their deposits.

…… Some observers are concerned that ……. the banks’ excess reserves will serve as kindling for an inflationary fire. This concern would have been entirely appropriate three years ago. But in October 2008, Congress granted the Federal Reserve the power to pay interest on bank reserves. Right now, that interest rate is 25 basis points, or 0.25%. By raising that rate judiciously, the Fed has the ability to deter banks from using their reserves to create money, and through this mechanism, the Fed can prevent inflation.

via Fed’s Kocherlakota on Why Balance Sheet Expansion Need Not Be Inflationary – Real Time Economics – WSJ.

Monetary expansion through further asset purchases by the Fed (quantitative easing) would be ineffective, simply boosting the level of excess reserves held by banks on deposit at the Fed. Monetary tightening would be more difficult, but could be achieved by raising the interest rate paid on excess reserves in order to discourage banks from using their excess reserves. That would raise the overnight rate (fed funds rate) in the market and restrict banks from expanding their balance sheets.

Causes of the Crisis: Basel II

Why do they [European financial institutions] hold so much Greek government debt? Because under Basel II, implemented (outside the United States) in 2007, Greek government bonds, rated A-, had the same 20 percent risk weight as AA/AAA asset-backed securities in the United States. That is, until S&P downgraded Greek debt from A- to BBB+. That raised the risk weight to 50 percent, suddenly requiring 60 percent more capital from banks holding Greek bonds.

This appears to be the reason that the possibility of Greek default has led to fears of another banking crisis.

via Causes of the Crisis: February 2010.

The 20 percent risk weight required banks to only hold $2 of bank capital against a $100 security — at the 8 percent Basel rate for adequately capitalized banks — allowing 50 to 1 leverage compared to 12.5 to 1 on normal bank loans.

Germany, France Hail Debt Progress –

According to a European Union official familiar with the situation, Germany and France are weighing two models but leaning towards using the fund to insure bonds from euro-zone countries.

….Germany and France are (also) fine-tuning a proposal for European banks to bring their core Tier 1 capital ratios, a key measure of financial strength, to 9%, within six to nine months, said the EU official, who spoke on condition of anonymity.

Europe’s two largest economies agree that the region’s banks should seek to raise funds in the open market and will suggest giving the banks up to nine months to fulfil the new capital requirements, the official said.

via Germany, France Hail Debt Progress –

IMF Survey: Weak and Bumpy Global Recovery Ahead

The risks to the global economy are many, but three in particular demand strong action by policymakers:

• In the euro area, banks must be made stronger, not only to avoid deleveraging and maintain growth, but also, and more importantly, to reduce risks of vicious feedback loops between low growth, weak sovereigns, and weak banks. This requires additional capital buffers, from either private or public sources.

• The top priorities in the United States include devising a medium-term fiscal consolidation plan to put public debt on a sustainable path and to implement policies to sustain the recovery, including by easing the adjustment in the housing and labor markets. The new American Jobs Act would provide needed short-term support to the economy, but it must be flanked with a strong medium-term fiscal plan that raises revenues and contains the growth of entitlement spending.

• In Japan, the government should pursue more ambitious measures to deal with the very high level of public debt while attending to the immediate need for reconstruction and development in the areas hit by the earthquake and tsunami.

via IMF Survey: Weak and Bumpy Global Recovery Ahead.