The transition to stronger capital standards for global systemically important banks (G-SIBs) in advanced and emerging economies after the global financial crisis is likely to have at most “a modest impact on aggregate output, while the benefits from reducing the risk of damaging financial crisis will be substantial”.
This is the nub of a major report released in Basel (Switzerland) jointly made by the Financial Stability Board (FSB) and Basel Committee on Banking Supervision (BCBS) in close concert with the International Monetary Fund (IMF) of the Macroeconomic Assessment Group (MAG).
It said weaknesses at large financial institutions have often played a key role in triggering and propagating systemic financial crises.
In its latest report, the MAG comprising macroeconomic modelling experts from central banks and regulators in 15 countries and a host of global institutions, the group drew on its earlier assessment of the transitional costs of the proposals for strengthened capital and liquidity requirements under Basel III and on the long-term cost-benefit analysis performed by the Basel Committee's Long-term Economic Impact (LEI) study.
Impact
The costs of the G-SIB proposals arise out of the adverse impact on economic activity, especially investment, of banks' actions to augment interest rate spreads and cut lending in order to build up their capital buffers.
The MAG estimated the impact of higher capital requirements on G-SIBs by scaling the impact of raising capital requirements on the banking system as a whole, reported by the MAG in 2010, by the share of G-SIBs in domestic financial systems.
While these shares vary across jurisdictions, the share of the top 30 potential G-SIBs (using the Basel Committee's proposed methodology and 2009-end data) averages about 30 per cent of domestic lending and 38 per cent of financial system assets in the MAG economies.
If lending shares are used as a scaling factor, raising capital requirements on the top 30 potential G-SIBs by one percentage point over eight years leads to only a modest slowdown in growth. GDP falls to a level of 0.06 per cent below its baseline forecast, followed by a recovery, the report said, adding that this signifies an additional drag on growth of less than 0.01 percentage points a year during the phase-in period.
The primary driver of this macroeconomic impact is an increase of lending spreads of 5-6 basis points. Soon after implementation is complete, growth is forecast to be somewhat faster than trend until GDP returns to its baseline.
The overall impact of the Basel III proposals (which apply to all banks) and the G-SIB framework is also quite small, with GDP at the point of peak impact projected to be lower by 0.34 per cent relative to its baseline level.
Roughly four basis points (0.04 per cent) are subtracted from annual growth during this period, while lending spreads rise by around 31 basis points, it said.
Long-lasting effects
The report asserts that the permanent benefits of the G-SIB framework stem from the reduced likelihood of systemic crises that can have long-lasting effects on the economy.
The MAG estimated that the Basel III and G-SIB proposals combined contribute a permanent annual benefit of upto 2.5 per cent of GDP — many time the costs of the reforms in terms of temporarily slower annual growth.
Stating that these results rest on a number of assumptions including about the role of G-SIBs in the financial system and about how banks will go about meeting stronger requirements, the report said many of these assumptions apply equally to the costs and benefits of higher capital levels.
For instance, it could be argued that G-SIBs play a unique role in the economy, so the transitional macroeconomic impact of their adjustment to higher capital levels should be greater than what is estimated in the report.
But if this is the case, the report said, the benefits from strengthening their balance sheets and thereby reducing the risk of a devastating financial tsunami should be greater as well.