New Research: The Costs of Capital Structure After Basel

New Research: The Costs of Capital Structure After Basel

The Basel Accords are a series of international banking standards for capital adequacy adopted by various countries around the world. Basel I was first issued in 1988, Basel II followed in 2004, and most recently Basel III was adopted in 2013.

A new paper from the Federal Reserve Bank of New York exploits a change in the way short-term bank liabilities were calculated for the purposes of determining capital requirements from Basel I to Basel II to determine the costs of additional capital to banks:

The Basel I Accord introduced a discontinuity in required capital for undrawn credit commitments. While banks had to set aside capital when they extended commitments with maturities in excess of one year, short-term commitments were not subject to a capital requirement. The Basel II Accord sought to reduce this discontinuity by extending capital standards to most short-term commitments. We use these differences in capital standards around the one-year maturity to infer the cost of bank regulatory capital. Our results show that following Basel I, undrawn fees and all-in-drawn credit spreads on short-term commitments declined (relative to those of long-term commitments). In contrast, following the passage of Basel II, both undrawn fees and spreads went up. These results are robust and confirm that banks act to conserve regulatory capital by modifying the cost and supply of credit.

Higher capital requirements require banks to finance more of their activities with equity, which is more expensive than debt because of explicit and implicit subsidies. Because short-term liabilities were excluded from determining capital requirements under Basel I, this created an incentive for banks to offer more generous arrangements with respect to short-term lending.

Of particular interest is the cost of capital to banks that can be estimated by looking at the change from Basel I to Basel II. Based on the different risk weights for liabilities required under Basel I, a $1 shift from long- to short-term lending reduced banks’ need to hold $0.02 in capital. Overall, based on the difference between the borrowing costs by shifting to short-term lending, “it suggests on the margin banks are willing to forego as much as $0.05 in profits for a $1 reduction in capital.”

Opponents of higher capital requirements will argue that these results show that requiring more equity imposes real costs on financial institutions and should therefore be avoided. Our conclusion in the opposite direction: this study supports the conclusion that the more favorable tax and regulatory treatment of debt results in a larger financial sector than would otherwise be the case, with negative consequences for both the efficiency of capital allocation and macroeconomic stability.

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By |2018-10-04T07:44:33-07:00October 4th, 2018|Blog, Financial Regulation|