March 3, 2016/IMF Staff Discussion Note

Executive Summary

Few issues have elicited a more contentious debate than the appropriate level of capital requirements. Proponents of stricter regulation point to the risks associated with high bank leverage and the exorbitant costs of the global financial crisis. Opponents of higher capital requirements argue that these may significantly increase the cost of bank credit and hinder economic activity.

This paper contributes to the debate by assessing the benefits of bank capital in terms of its ability to absorb losses. Its findings support the range of loss absorbency suggested by the Financial Stability Board (FSB) and the Basel Committee for systemically important banks. We measure these benefits against the yardstick of how much capital would have been needed to avoid imposing losses on bank creditors or resorting to public recapitalisations in past banking crises. The paper also looks at the welfare costs of tighter capital regulation by reviewing the evidence on its potential impact on bank credit and lending rates.

Our analysis of how capital increases banks’ capacity to absorb losses and the associated benefits is subject to several caveats. First, the analysis is based on a macro approach, given the dearth of bank-level data on losses during crises. Second, it relies on the precision and comparability of available (country-level) data on nonperforming loans and loss given default ratios in past banking crises, and on other balance sheet parameters employed to convert losses into capital needs. Reassuringly, different exercises lead to similar conclusions. With these caveats in mind, the paper reaches the following tentative conclusions.

First, based on our methodology, capital in the range of 15–23 percent of risk-weighted assets would have been sufficient to absorb losses in the majority of past banking crises (at least in advanced economies).

Further capital increases would have had only marginal effects on preventing additional crises, suggesting that this level of loss-absorption capacity is, on average, appropriate for advanced economies. That said, from a regulatory standpoint, appropriate capital requirements may be below this range, as banks tend to hold capital in excess of regulatory minima, and other bail-in-able instruments can contribute to loss absorption capacity.

Second, institutional and regional factors might lead to variations in the appropriate levels of capital and loss-absorption capacity across jurisdictions. For instance, emerging markets have, on average, suffered greater bank losses (relative to bank assets but not to GDP) during crises and imposed tighter requirements.

The extent to which institutional improvements (in regulation, supervision, resolution, and governance) can help reduce the required levels of loss absorption is an open question.

Third, the short-term costs of transitioning to higher capital standards might be substantial and much higher than long-term costs. Any new regulatory minima should therefore be imposed gradually, when conditions allow, and over a relatively long period of time. However, experience shows that when regulators set new minimum capital requirements based on solid economic and financial foundations, markets tend to anticipate full compliance with new standards ahead of phase-in periods.

Also, supervisors should encourage banks to increase loss absorption by raising equity (through new issuance or retained earnings) rather than shrinking assets, so as to avoid reduced credit availability.

Finally, tighter requirements on banks may provide stronger incentives for regulatory arbitrage and increase the risk that activities might migrate to unregulated or less regulated financial intermediaries (the so-called shadow banking system). In that context, it is essential to widen the perimeter of prudential and macroprudential regulation.

Click here to download full report “Benefits and Costs of Bank Capital”-IMF