Banking regulations post-crisis and their effect on SME lending. Robert Carpenter

Banking regulations post-crisis and their effect on SME

lending

Robert E. Carpenter

Department of Economics, University of Maryland, Baltimore County

Lead Financial Economist, Supervision, Regulation, and Credit/Risk and

Policy, Federal Reserve Bank of Richmond

Confidential InformationConfidential Information

A very important disclaimer

• Everything I say is only my opinion and does not reflect the opinion of the Federal Reserve Board or the Federal Reserve Bank of Richmond

• Nothing I say should be interpreted as representing, or even hinting at, the position of the US Government (which I do not represent)

• The past two weeks and why I think it matters for people interested in the growth of the SME sector

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Our past month has been a busy one

• Worrying about the likelihood of success for the budget negotiations between the President and Congress and the consequences if they didn’t

• Worrying about the effects of S&P’s decision to downgrade US debt from AAA to AA+

• Worrying about troubling data releases about the pace of economic recovery both in the US and abroad

• More or less constant worry about the potential consequences of the European sovereign debt crisis

• It seems almost quaint to talk about the implementation and impact of new (and very important) regulatory capital standards and its effect on lending and SME lending

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I want to make 4 basic points

• Increasing the amount of capital banks are required to hold and increasing its quality changes investor incentives in a way that should reduce risk in the system, other things being equal

• But there are, as always, tradeoffs

• The macroeconomic impact of Basel III should reduce lending flows in addition to risk. However, estimates of their size focus on prices as the margin of adjustment (lending rates) not quantities

• This difference matters importantly for certain types of enterprises

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• Leaving countries free to determine the counter-cyclical capital buffer provides them with some incentives that run counter to promoting stability in a broad sense

• Instability affects risk appetitive, and SMEs are well known to be risky ventures (just look at yesterdays data presentation)

• It is important that there be well understood definitions, observable to market participants, that determine whether a financial institution is a SIFI or G-SIFI

• Ambiguity in the definition of a SIFI (or GSIFI) may be counterproductive

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What is Basel III?

• Because this is a mixed conference, let me give a very quick introduction

• Bank capital, in its simplest form, is the portion of the banks assets that have no contractual commitment for repayment

• Retained earnings or paid in capital are examples

• Bank capital serves as a shock absorber to protect against declines in asset values, and therefore it protects depositors against loss, or it protects the deposit insurance fund

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Incentives matter

• Shareholders, bank managers, depositors, and regulators all have different incentives here

• The less capital held by banks, the more risk, but also more return to owners because the bank is more highly levered (concentrates gains on a narrower equity base)

• Since depositors are much like bond holders (and receive a fixed claim) more risk provides them with little benefits

• Because more risk increases the probability of failure, it increases the costs of failure, which include costs to the deposit insurance fund and potential threats to systemic stability

• Regulators require banks to hold minimum capital levels

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What is Basel III, then?

• Basel III is the set of accords that layout minimum capital levels relative to banks’ risk weighted assets

• The idea is that riskier assets require more capital to be held against them (a bigger buffer)

• The noteworthy features of Basel III, not all of which I’ll cover include

• Requiring much more, and higher quality capital

• A “capital conservation buffer” which, as it becomes depleted, leads to restrictions on the bank to pay dividends

• A “countercyclical capital buffer” which is designed to slow the flow of credit to overheated markets

• Two new liquidity standards to reduce the probability of a “Lehman style” run on banks active in wholesale funding markets

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A summary sheet for Basel III

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The economics of Basel III

• I have heard one comment many times; enough times that I want to address it first

• “Basel III increases capital requirements, which will push institutions subject to it further out on the risk curve”

• I understand the argument, but it is difficult to see how it can be true in equilibrium.

• This issue split the conference I attended on my way here

• The easiest way to about this issue is to recall some basic principles of finance

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The basic argument

• ROE = ROA * EQUITY MULTIPLIER

• EQUITY MULTIPLIER = ASSETS / EQUITY

• So, if Basel III increases required capital, which it does, the equity multiplier falls.

• If investors were to require the same ROE after implementation, ROA must rise

• To raise ROA, other things constant, you must take on additional risk

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Why abandon the first principles of finance?

• One of the basic principles of finance is that earning a higher return requires investors to bear more risk

• That concept operates in reverse, too

• If you bear less risk, you require a lower return

• What that means is as capital rises, investors should respond by requiring lower ROA, in equilibrium

• The bottom line is that “skin in the game” matters for incentives

• More skin in the game, i.e., more capital should reduce the taste for risk

• There is a potential, then, for SMEs to see a decline in lending that might be especially pronounced in bank dependent systems

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• Most estimates suggest that the increase in loan spreads that result from Basel III will be relatively small

• Most estimates from the economics research literature suggest that capital spending (plant and equipment) is interest inelastic (insensitive to changes in interest rates)

• Put a small change in interest rates together with investment that is insensitive to changes in interest rates and you get a small macroeconomic impact

• The big question in my mind is what sorts of activities, or loans, institutions will shed disproportionately as they reduce their risk profiles?

• The second big question is what the margin of adjustment will be, prices or quantities

• It matters. But more on this later

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Some detail on the macroeconomic impact

• OECD: Banks pass on their higher funding costs through higher 15bps loan spreads. Reduces GDP growth by 5-15bps per year during the rollout

• Banca d’Italia: 3-39bps of reduced GDP per percentage point of increased capital, 0-5bps of reduced GDP growth per percentage point of increased capital

• NY Federal Reserve: 9bps reduced GDP per percentage point in increased capital. An additional 8 bps reduced GDP attributable to the new liquidity standards. “Consistent with the Macroeconomic Assessment Group (MAG)” of the BIS

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What’s the big picture from all of this?

• First, the effect of the higher capital requirements is on the level of GDP during the transition period, also the growth

• From a big-picture macroeconomic modelling perspective, this is as it should be. Macroeconomic growth rates, in these models, shouldn’t be lower after the phase in

• Second, it is fair to say that the macroeconomic costs estimated by the most of the models are modest

• The models don’t necessarily account for the facts that many institutions may not find the Basel regulatory constraints binding. Markets may well require (and in fact do appear to require) institutions to hold capital in excess of the minimums

• Lastly, in economics we usually think of benefits net of costs, or costs net of benefits. Most of these models recognize, but do not calculate, the benefits of Basel III

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Some caveats worth thinking about• Even though the transition period costs are modest per

percentage point of additional capital, the timing is unfortunate, as many advanced economies are growing quite slowly

• Firms that depend on internal funds for growth are particularly impacted, as well as those entrepreneurial firms that depend on using household assets as collateral

• What are the size of the net costs (or benefits) of Basel III?

• BIII should reduce risk. From a theory standpoint reducing risk means reducing volatility. From a practical standpoint that means reducing the output costs of financial shocks

• How big are those benefits? It depends on the shape of recessions caused by the shocks. The benefits of reducing negative shocks is bigger the bigger they are and the longer their duration (the current shock is both big and long)

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More tradeoffs: troughs and peaks

• While BIII should help to shave the bottom off future troughs, will it also shave some of the tops from future peaks?

• Counter cyclical capital charges of 0-2.5% are to be levied during periods of “excess” credit growth

• Laudable goal of reducing pro-cyclicality of capital

• Also have the impact of reducing the flow of credit in markets that might be “overheating”

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Two reasons for rapid credit growth• Credit may grow rapidly in a sector if incentives are

misaligned and the financial asset in question is more opaque for sellers than it is for buyers.

• Many have argued this combination existed in mortgage markets

• Credit may also grow rapidly in a sector where there is a technological innovation that increases productivity or returns

• Efficient capital markets will provide capital to markets with high returns…rapidly, if investors and entrepreneurs believe that there are first mover advantages

• Asset prices may also rise rapidly, and no doubt many observers will characterize this as a “bubble” especially if as a result of an industry shakeout over standards or production technology, some early entrants to the industry exit it

• I would not like the job of having to separate “bubbles” from innovations

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The countercyclical capital buffer

• Is designed to slow the supply of credit when it is expanding rapidly

• Will that slow the pace of developing newly identified innovations (which often take place in SMEs)?

• Will it change the dynamics of innovations, by raising entry barriers to late entrants, who may have superior technologies?

• My point is to state simply that reducing risk/variance through counter cyclical capital buffer has more than one impact

• Measures to reduce the variance of output by slowing the supply of credit when it is growing rapidly may reduce the number of observations we see in the left tail, but may also reduce the number of observations we see in the right

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Opportunities for mischief

• Because the counter cyclical capital buffer can be “implemented according to national circumstance” it introduces the possibility of setting the buffers size based on factors other than promoting stability

• Take two countries: A and B. Country A has the (A)veragecountries view about stability. Country G values (G)rowthin its financial sector for economic or political reasons

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Coordination problems

• Suppose an apparent technical innovation occurs, which leads to a rapid flow of lending into that sector

• Country A, because it values stability, may implement a high countercyclical buffer. Country G may see this as an opportunity to increase the prominence of its financial sector and set a lower buffer

• If G’s banks receive funding from A’s, it also passes some of the cost of that choice to A, in effect borrowing a portion of the buffer

• While in principle international coordination would be a solution, it also assumes away the problem (that countries with different objectives may choose not to coordinate)

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The methodology to identify SIFIs and GSIFIs

• There’s agreement that “Systematically Important Financial Institutions” should have to hold capital in excess of the minimums

• What incentives does an institution have?

• Does it want to be categorized as a GSIFI?

• If it does, it will be subject to a higher amount of regulatory scrutiny, and it will be subject to the higher capital requirements associated with being a SIFI

• On the other hand, GSIFIs might be viewed as being more likely to receive support in the event of a financial shock, and this support might lead it to be able to attract funds at below market rates

• More likely to have access to the safety net

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Why transparency is important

• The best of both worlds might be for a firm to become large enough so there is some uncertainty about whether it is a GSIFI

• In that case

• Market participants might believe that there is a good probability that it would receive support in the event of a systemic shock

• But it might not be so large that it incurs the extra regulatory scrutiny or GSIFI capital charge

• You might argue that a public list solves this problem, but I would respond it is the firms that are almost on the list that I am concerned about

• A transparent methodology, and a credible commitment not to treat near SIFIs as SIFIs in a shock, is helpful

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Some “finer” macroeconomic details

• Recall that most (but not all) estimates of the macroeconomic impact of BIII focused on increases in lending rates

• If investment is interest inelastic (and there is a great deal of evidence from the academic literature suggesting that its is) then small changes in interest rates lead to small changes in investment

• Hence the small estimated impacts

• Not everyone, in either policy circles or in academics, views focusing on interest rates as the margin of adjustment is a complete story

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Quantities matter

• There is an important literature in economics (where two Nobel prize winners work) that argues interest rates aren’t always used to ration credit in financial markets

• Adverse selection and moral hazard, coupled with asymmetric information between borrowers and lenders means that increasing interest rates can lower borrower returns

• In that case, they may employ “credit rationing” to allocate credit.

• Since most of the models estimating the macro effect of BIII do not consider this channel, they may not capture the full output costs of higher capital standard

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What sort of firms, what kind of output costs?

• The research literature in economics has suggests that small, entrepreneurial firms face difficulties in attracting outside financing

• If the adjustment margin to BIII is quantities (reduced availability) it may slow the birth of new firms or reduce the growth of SMEs

• SMEs are often the focus of economic development policies and sometimes account for a great deal of gross (but not necessarily net) job formation

• The potential output costs are larger for firms operate in economic systems where alternatives to bank finance are less available

• The standard examples of bank dependent economies those of continental Europe

• What’s the potential distributional impact across countries?

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Some final thoughts

• Basel III is quite complicated, it’s implementation is complicated, measuring it’s output costs is complicated, predicting institutions, and regulators, reactions to it is complicated, and it’s being implemented in a complicated environment

• But one thing that isn’t particularly complicated is that more capital, and higher quality capital, should reduce the risk of costly financial shocks

• Those costly financial shocks have a particularly large impact on entrepreneurial ventures, both in formation rates and survival rates

• The tradeoff is how the response of the financial system will affect to regulatory reform will effect the growth and survival of SMEs going forward, and so your work is more important than ever

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Banking regulations post-crisis and their effect on SME lending. Robert Carpenter

Economy & Finance

Transcript of Banking regulations post-crisis and their effect on SME lending. Robert Carpenter