Wednesday, February 8, 2012

The Global Macroeconomic Costs of Raising Bank Capital Adequacy Requirements

The Global Macroeconomic Costs of Raising Bank Capital Adequacy Requirements. By Scott Roger & Francis Vitek
IMF Working Paper No. 12/44

Summary: This paper examines the transitional macroeconomic costs of a synchronized global increase in bank capital adequacy requirements under Basel III, as well as a capital increase covering globally systemically important banks. The analysis, using an estimated multi-country model, contributed to the work of the Macroeconomic Assessment Group analysis, especially in estimating the potential international spillovers associated with a global increase in capital requirements. The magnitude of the effects found in this analysis is relatively modest, especially if monetary policies have scope to ease in response to a widening of interest rate spreads by banks.



1. This paper analyzes the transitional macroeconomic costs of strengthening bank capital adequacy requirements, including a general increase in capital requirements as well as an increase specifically for globally systemically important banks (GSIBS). In addition to estimating the impact of introducing higher capital requirements in each of 15 major economies, the analysis also includes estimates of the international spillover effects associated with the simultaneous introduction of higher capital requirements by all 15 countries. The simulations are generated within the framework of an extended and refined version of the multi-country macroeconometric model of the world economy developed and estimated by Vitek (2009).

2. This analysis contributed to the work of the Macroeconomic Assessment Group (MAG), chaired by the Bank for International Settlements (BIS), and the Long-term Economic Impact (LEI) group of the Basel Committee for Banking Stability (BCBS).1 The MAG participants, including the IMF, used a variety of models to estimate the medium-term macroeconomic costs of strengthening capital and liquidity requirements.2 The analysis presented in this paper, reflecting the MAG mandate, focuses solely on the short-term to medium-term output costs of the proposed new regulatory measures. Estimates of the net benefits of these regulatory measures can be found in the LEI report (BCBS 2010).

3. The macroeconomic effects of an increase in capital adequacy requirements are assumed in this analysis to be transmitted exclusively via increases in the spread between commercial bank lending rates and the central bank policy rate. We estimate that, in the absence of any monetary policy response, a permanent synchronized global increase in capital requirements for all banks by 1 percentage point, would cause a peak reduction in GDP of around 0.5 percentage points, of which around 0.1 percentage points would result from international spillovers. Losses in emerging market economies are found to be somewhat higher than in advanced economies. If monetary policy is able to respond, however, the adverse impact of higher capital requirements could be largely offset.

4. With regard to strengthening capital requirements specifically for GSIBs, we estimate that a 1 percentage point increase in capital requirements for the top 30 GSIBs would cause a median peak reduction in GDP of around 0.17 percentage points, of which 0.04 percentage points, or 25 percent, results from international spillovers. The aggregate figures conceal a wide range of outcomes, however, and for some countries, international spillovers would be the main source of macroeconomic effects.

5. It is important to bear in mind the limitations of the model and assumptions used in the analysis. In particular, the analysis does not take account of other possible responses by banks or other financial institutions to changes in capital requirements, or non-linearities in the response of financial systems, monetary policy, or the real economy. Nor does the model allow for changes in the macroeconomic steady state associated with very persistent widening of lending spreads. Additionally, the analysis does not take account of the different initial starting points of different countries in raising capital requirements, or differences in the speed of implementation. 

Concluding comments and caveats

28. The multi-country macroeconomic model used in this analysis contributed importantly to the MAG assessments of the potential impact over the medium term of a global increase in capital requirements, both for all banks and for a smaller group of GSIBs. The results of the multi-country analysis indicate that international spillovers associated with coordinated policy measures are important—our analysis suggests that spillovers typically account for 20- 25 percent of the total impact on output. Moreover, in the case of an increase in capital requirements for GSIBs, international spillovers may be the primary source of macroeconomic effects.

29. At the same time, it is important to recognize the important limitations associated both with the model and with the exercise it was used in. With regard to the model, the main limitations to emphasize are that:
* As discussed earlier, the model is not geared to dealing with changes in the steady state associated with permanent or very persistent shocks. Although the quantitative significance of this does not appear to be large in the context of this exercise, it suggests that the estimated effects of a permanent increase in interest rate spreads should be interpreted with caution, particularly at long horizons.

* The model has only one avenue for the increase in capital requirements to affect the real economy; though a widening of bank lending spreads over the policy rate. As discussed in the MAG reports, there are several ways in which banks can respond to higher capital requirements and some could have much more significant effects on output, while others would be more benign.

30. The exercises themselves have some important limitations that should be borne in mind in assessing the quantitative results and risks surrounding them. These include:
* The implementation of the higher capital requirements is assumed to be linear over the alternative implementation periods. In practice, the speed of implementation is quite likely to be non-linear; indeed, markets may be forcing a front-loading of adjustment.
* The scope for monetary policy responses may well vary over time and differ from one country to another. Not all countries are close to the zero lower bound for interest rates, and even those that are may not remain so over the entire implementation period.  Consequently, macroeconomic outcomes and spillovers are bound to differ from those suggested by the model analysis. The analysis should be thought of as showing bounds for potential outcomes associated with different monetary policies.

* The analyses only consider standardized increases in capital requirements by 1 percentage point. However, the effects of increases in requirements may well be nonlinear, so that increasing requirements by 2 percentage points may be not be simply twice as much as a 1 percentage point increase, and the degree of non-linearity may not be the same across time or countries. The zero lower bound constraint is one such nonlinearity, but there are likely to be others.

* The analysis of the global increase in capital requirements assumed an identical increase in capital requirements in all countries. In reality, banks in some countries will have much further to go in meeting higher capital requirements than banks in other countries. As a consequence, the pace of increases in interest rate spreads will vary across countries. As seen in the exercise with GSIBs, where spreads increased by different amounts in different countries, this would significantly modify the pattern of macroeconomic effects and their spillovers between countries.