Australia’s banking regulator, APRA, has been forcing Australia big banks and Macquarie to hold more capital lately.
It’s all part of the push to make the financial system as resilient as possible when the next, inevitable, economic downturn comes.
It’s also supposed to protect the economy if an economic downturn, either here or abroad, leads to a systematic financial crisis. So to this end APRA, and the global central banking overlords in Basel, are also increasing the liquidity banks must hold and reducing their balance sheet leverage.
But it doesn’t come without cost.
The banks have to pay for the capital they raise. That cost, and the dilutive effects of holding more capital per asset on balance sheet and having less leverage, lowers returns. Particularly returns on equity.
Naturally, as we have seen recently in Australia, bank managers are keen to recoup some or all of those costs by increasing the interest rates they charge borrowers. How this interplay between higher bank capital, lower leverage and increased costs to borrowers plays out in the economy is hard to quantify in an economy.
Or it was.
Overnight the Bank of International Settlements, the central banking overlord, released its quarterly review. One part of that review was a specific look at “the long-term economic impact of stronger capital and liquidity requirements”.
They looked at the expected benefits of avoiding systemic crises as compared with the expected costs of higher capital in terms of reduced output. The BIS says it’s an intentionally conservative estimate which makes “assumptions that tend to raise cost estimates and downplay expected benefits, introducing a downward bias into the estimates of expected net
By multiplying the “probability of systemic financial crises, given different minimum capital ratios, by the expected macroeconomic costs of such crises should they occur”, the BIS found that the “median cost of systemic banking crises” in a number of academic studies “is 63% of GDP in net present value terms”.
As reported by the ABS in last week’s national accounts, Australia’s GDP was around $1.6 trillion. While it’s not a perfect comparison, if, as the BIS suggests, Australia avoids a systemic crisis which would cost 63% of Australian GDP then the economy is around $1 trillion better off.
The BIA highlighted “higher bank capital requirements raise banks’ costs, banks may respond by raising their lending spreads to counterbalance the decline in their return-on-equity (RoE)”.
That’s what we’ve seen in Australia recently.
“As a result, real economy borrowing costs may rise, translating into lower investment and equilibrium output,” the BIS says.
So, in order to estimate the magnitude of this effect in the long run, the BIS said its work:
Assumes that banks maintain a constant RoE by passing on to their customers all additional costs that are due to higher capital requirements. The estimated increase in lending spreads is then fed into a variety of macroeconomic models (that is, the dynamic structural general equilibrium models and semi-structural and reduced form models in use at participating central banks) to assess the resulting impact on GDP.
The result is that “a 1 percentage point increase in the CET1/RWA ratio translates into a 0.12% median decline in the level of output relative to its baseline (with the corresponding value for the liquidity requirements being a one-off 0.08% decline in the output level),” the BIS said.
APRA said earlier this year it wanted the majors to hold an extra 2% of capital, which implies a 0.24% decrease in GDP. Using the same Q3 national accounts data, that cost to the economy is about $3.84 billion.
That means that as disagreeable as many have found the banks pass-through of increased capital costs to customers, the net benefit to the Australian economy from APRA and the banks’ action is clear. That is, the economy is far better off if this extra capital can forestall a systemic crisis.
But there is also something uncomfortable about this analysis. It feels like comparing apples with oranges and an attempt by the BIS to justify its actions. That’s because we have a known cost to the economy of the increase in capital but an expected saving from an event that may never occur.
Either way though, the key finding is clear.
“Even large increases in bank capital requirements from their pre-crisis levels are unlikely to result in macroeconomic costs that outweigh the associated benefits in terms of reduced crisis costs,” the BIS said.
The good news, or at least the BIS hopes, is that it also says “banks’ required RoE can be expected to decline as their balance sheet leverage and the riskiness of their equity fall”.
Maybe the economy will get some of that cost back eventually with lower rates.