Fixing What Ain’t Broken: The Real and Hidden Costs of Excessive Bank Capital Regulation

Introduction

Large banks have seen both the absolute and relative amount of capital they maintain increase steadily over the past fifteen years.  Today, Financial Services Forum members maintain nearly a trillion dollars in high-quality capital that stands ready to absorb financial losses while promoting a safe and sound banking sector.  Despite the strength of today’s largest banks, some believe perhaps there is more room to grow bank capital requirements.  In this post, we review the research on both the direct and indirect costs of bank capital regulation.  Overall, independent academic research finds that a substantial increase in bank capital requirements could raise annual borrowing costs by roughly 0.25 percentage points while costing the economy over $100 billion per year while also incentivizing continued growth of the shadow banking sector.

The Direct Costs of Bank Capital – Higher Borrowing Costs and Lost Economic Output  

Economists agree that increasing bank capital requirements increases the cost of bank lending and depresses economic activity.  As we have discussed in previous posts, equity capital is an expensive form of finance, so requiring banks to use more of it raises costs in exactly the same way that requiring a more expensive grade of steel would increase the cost of building a car.  Economists do hold a range of views, however, about the precise impact of raising capital requirements on the cost of bank lending.  As in all economic phenomena, the basic problem is one of observability: we never see a bank change its capital level in isolation.  Almost always other important determinants of bank borrowing costs – macroeconomic conditions, competition in the loan market, etc. – are also changing, making it hard to isolate the pure impact of increasing bank capital requirements.

Over the past decade, economists have studied the cost of increasing bank capital requirements on borrowing costs and the rest of the economy.  These studies examine data on bank capital levels, borrowing costs, and other macroeconomic fundamentals to identify the impact of an increase in bank capital requirements.  In Table 1 below, we show the results of thirteen different academic studies.  We show the impact of increasing capital requirements on the annual cost of borrowing as well as the associated annual reduction in U.S. GDP.  The estimated impact on borrowing costs comes directly from each study that is cited.  The impact on GDP is calculated following a methodology employed by Cline (2015) because not all studies consider the GDP costs of increased capital requirements.  Finally, we show the costs of higher capital requirements from a one percentage point increase in capital requirements (e.g. increasing capital requirements from 12% to 13%) as well as a 2-1/2 percentage point increase in capital requirements (e.g. increasing capital requirements from 12% to 14.5%).  This range covers the potential increase in capital requirements that could result from implementing Basel III Finalization in the United States.

Table 1: Estimated Increase in Lending Rates and GDP Costs from Increasing

Capital Requirements: Research Findings

*The table reports the increase in loan rates (measured in basis points) resulting from either a 1 or 2.5 percentage point increase in required capital ratios.  The estimates are taken directly from the referenced research papers.  In cases where a paper offers a range of estimates, the central tendency of the estimates is reported.  The table also reports the annual U.S. GDP cost of increasing regulatory capital ratios using Q3 2022 nominal GDP.  The translation of increased loan spreads to a decline in GDP is performed using the methodology of Cline (2015).  The specific formula employed is that the annual GDP cost is calculated as: loan rate increase (bps) X 1/460 X 1/3 X 0.25 X 2023 Q3 Nominal GDP.  See Cline (2015) for more details.  The results for a 2.5 percentage point increase are 2.5 times the results for a 1 percentage point increase.    

As shown in Table 1, raising capital requirements by 2.5 percentage points could raise borrowing costs by 0.24 percentage points and cost the U.S. economy over $110 billion dollars each year in lost output.  As these studies clearly document, rigorous, data-based economic analysis consistently finds that raising capital requirements increases borrowing costs and depresses the economy.  Moreover, these costs impact the economy each and every year, resulting in a constant drag on economic performance.

The Indirect Costs of Bank Capital – Incentivizing the Growth of Shadow Banking

The research papers cited in the table above document the direct costs of increased bank capital requirements.  While direct costs are clearly important, there is more to consider.  Specifically, increasing the cost of bank-intermediated finance is likely to increase the size and reach of less regulated non-bank financial intermediaries, or “shadow banks.”  Indeed, the work of Kashyap, Stein, and Hanson (2010) directly addresses the non-bank issue.  They caution against significant increases in bank capital because “even these modest effects raise significant concerns about migration of credit-creation activity to the shadow-banking sector, and the potential for increased fragility of the overall financial system that this might bring.”  As regulated banks face ever-higher capital requirements, the incentives for financial activity to migrate to shadow banks are simply too large to ignore.

And since Kashyap, Stein, and Hanson published their findings in 2010, we have continued to witness more rapid growth among shadow banks as well as the implications of that growth.  According to the Financial Stability Board’s (FSB) most recent report on non-bank financial intermediation (NBFI), the share of financial assets controlled by NBFI’s has grown to 49.2% in 2021 from 46.7% in 2014.  The report also shows that the rapid growth in the shadow banking sector accelerated during the pandemic.  Specifically, the report states that “the NBFI sector grew by 8.9%, higher than its five-year average growth rate of 6.6%.”  In addition, according to the FSB, much of the financial instability that occurred during the COVID pandemic can be traced to fragile segments of the shadow banking sector, which stands in stark contrast to the strong and shock-absorbing performance of the banking sector during the same period.  In particular, in a review of the financial turmoil accompanying the pandemic, the FSB stated that “the March 2020 market turmoil underscored the need to strengthen resilience in the non-bank financial intermediation sector.”

Increasing capital requirements for regulated banks will only increase the share of financial activity undertaken by non-banks, leading to increased financial stability risks.  And while some have suggested that the appropriate response is to enhance the regulatory oversight of non-banks little has been done over the past decade to address the supervision and regulation of non-banks and there are no clear plans to do more in the near term.  Accordingly, increasing bank capital would likely only lead to a larger non-bank sector.

Conclusion

Large bank capital and prudential regulation has increased markedly over the past fifteen years, resulting in a safer and more stable banking sector.  The recent COVID pandemic served as a real-world stress test that underscored the resiliency and strength of large banks.  Raising bank capital requirements further risks subjecting the U.S. economy to unnecessary economic costs while hastening the growth of shadow banking.  Given the extensive improvements to the regulation of large banks over the past fifteen years, there is simply no compelling case that more capital is needed for large banks.  The economy would be best served if regulatory oversight were applied first to those sectors of the financial system subject to the least regulation and the most rapid growth while ensuring that large, regulated banks are not constrained from serving the economy.