Measuring the macroeconomic costs and benefits of higher UK bank capital requirements

Our Financial Stability Papers are designed to develop new insights into risk management, to promote risk reduction policies, to improve financial crisis management planning or to report on aspects of our systemic financial stability work.
Published on 01 December 2015

Financial Stability Paper No. 35
By Martin Brooke, Oliver Bush, Robert Edwards, Jas Ellis, Bill Francis, Rashmi Harimohan, Katharine Neiss and Caspar Siegert

The baseline bank capital requirements in the United Kingdom are being set to comply with agreed international standards established in Basel III (as implemented in Europe through CRD IV). The minimum Tier 1 requirement to be met at all times is 6% of risk-weighted assets, comprised of at least 4.5% Common Equity Tier 1 and at most 1.5% Additional Tier 1 capital. Internationally-agreed buffers, on top of this minimum, can be used to absorb losses under stress.

This paper assesses whether these baseline requirements are appropriate for the United Kingdom, given the characteristics of the banking system and economy, and taking into account other areas of regulatory change such as liquidity requirements, structural reform and, most notably, the recent development of a bank resolution regime and requirements for additional capacity to absorb losses in resolution. In November, G20 leaders endorsed standards agreed by the financial Stability Board for global systemically important banks to meet a minimum amount of Total Loss-Absorbing Capacity (TLAC). In December, the Bank of England will, in line with statutory requirements, consult on proposals for additional loss-absorbing capacity for other UK banks.
 
This paper uses a framework that measures and compares the macroeconomic costs and benefits of higher bank capital requirements. The economic benefits derive from the reduction in the likelihood and costs of financial crises. The economic costs are mainly related to the possibility that they might lead to higher bank lending rates which dampen investment activity and, in turn, potential output.

Using this conceptual framework, studies conducted in the aftermath of the financial crisis, such as the one by the Basel Committee on Banking Supervision, found appropriate Tier 1 capital ratios of 16-19% - well above the agreed Basel III standards. But our analysis suggests that:

  1. once resolution requirements and standards for additional loss-absorbing capacity that can be used in resolution are in place, the appropriate level of capital in the banking system is significantly lower than these earlier estimates, at 10-14% of risk-weighted assets.
  2. The appropriate level of bank capital varies significantly with the risk environment in which the banking system operates. Our main conclusions relate to typical risk environments. But we also find that in periods where economic risks are elevated – such as after credit booms – the appropriate level of capital would be much higher.
  3. It would be inefficient to capitalise the banking system for these elevated risk environments at all times, based on our analysis of the economic costs of higher bank capital levels. This motivates the use of time-varying macroprudential tools, such as the countercyclical capital buffer.

As discussed in the December 2015 Financial Stability Report, the Financial Policy Committee took the results from this analysis into account when forming its view on the overall capital framework for UK banks.

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