Essay Finance

8/2/2019 Essay Finance

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EC 2008

Topic 2. The proposed rules would have driven capital requirements up for all

banks, forcing the quality and quantity of these capital cushions to grow

That would be expensive for banks, because the money sits on banks' balancesheets and essentially can't be invested to bring in more profits.

Comment on this quotation providing a theoretical background to your

arguments.

Student ID Number: 090001720

Word Count: 1,000


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Student ID: 090001720

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The proposed rules would have driven capital requirements up for all banks, forcing the

quality and quantity of these capital cushions to grow That would be expensive for

banks, because the money sits on banks' balance sheets and essentially can't be invested to

bring in more profits. Comment on this quotation providing a theoretical background to

your arguments.

The new proposed set of capital rules following Basel III has sparked lively debate and

discussion. This essay will evaluate the two aspects of these proposals raised by the

quotation; namely the claim that the proposed capital ratio rules will allow for a more secure

banking system and the claim that this same measure will be costly to banks. The former is

analysed in terms of the financial theory behind capital ratios and is criticized for potentially

being made irrelevant by its neglect of the, asset-side, systematic risk-evaluation issues that

have been blamed for the recent crisis. The latter will be evaluated with reference to the

notion of return on equity in relation to attractiveness to investors in addition to the influence

of prevailing tax regimes. The impact of this cost to banks will then be compared to gains

made in terms of greater security.

The rules proposed in Basel III aim to increase the security of deposits by increasing the

required capital that needs to be reserved by banks in the form of common equity, in other

words risk-free capital.1

This makes banks more secure by increasing their ability to

withstand shocks such as defaults and other losses of assets without going insolvent. The

proposed changes would increase capital ratios for risk-weighted assets from 2% to 7%

increasing the quantity of money that is available to banks in cases where it is needed. Banks

only need to hold capital to support their risk-bearing assets and the quantity they need to

hold is in proportion to that risk. Taking a hypothetical example of Bank A that uses the old

2% capital to risk-bearing asset ratio and Bank B with the proposed 7% ratio we can see the

difference in relation to the capacity to withstand write-offs.

1Miles, David. Speech entitled: Monetary Policy in Extraordinary Times. Centre for Economic Policy Research

and London Business School. London. 23 February 2011.


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Balance Sheet for Bank A (2% Capital to Assets Ratio),

Assets Liabilities

Reserves

+10mLoans

+100m

Checkable Deposits

+108mBank Capital

+2m

(10m x 0 + 100m x 0.2 = 2m)

For a total capital of 110m, where 10% is held as reserves (which is risk-free) Bank A can

be certain to write-off only up to 2m in bad loans without having to sell assets while Bank B

can accommodate up to 7m. Unlike particular assets a bank may hold, this capital is

considered risk-free and is available immediately. This is not the case with assets such as

illiquid tangible assets the value of which assets may both vary according to economic

circumstances and the nature of the asset. This means we also have an improvement in the

quality of available capital, instead of merely increasing quantity of capital we are also

increasing the quantity of capital that is guaranteed to be available when needed.2

Therefore,

increasing the amount of capital banks hold should put them in a much more secure position

and help prevent future crises.

It has been argued, however, that the underlying problems that led to the recent crisis have

not really been dealt with. The suggestion is that Basel III doesn't address the principle

2Miles, David. Speech entitled: Monetary Policy in Extraordinary Times. Centre for Economic Policy Research

and London Business School. London. 23 February 2011.

Balance Sheet for Bank B (7% Capital to Assets Ratio)

Assets Liabilities

Reserves

+10m

Loans

+100m

Checkable Deposits

+103m

Bank Capital

+7m

(10m x 0 +100m x 0.7 = 7m)


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contribution of Basel II to the last financial crisis, namely, the calculation of risk-weights3.

Risk-weighting means that while assets bearing risks need to be backed by capital however,

extremely low-risk assets [can] be held with very little or even no capital.4

The incentive

to "manufacture" apparently risk-free assets out of risky pools5

that led to the

securitisation of sub-prime loans is still there and may easily overpower the increased in

capital ratios. At the same time, risk [is still] calculated primarily by...the recognised ratings

agencies6. Regarding the aftermath of the previous crisis the Securities and Exchange

Commission concluded that credit rating agencies did not properly manage theirconflicts of

interests when assigning ratings to structured products7. These conflicts of interests both in

terms of bankers and credit rating agencies are still present and present a serious threat to the

system.

We can now move to the question of why increased risk-weighted capital ratio is costly for

banks. Increasing the capital banks are required to have is expensive for banks8

because

holding more risk-free capital reduces the return on equity. Equity holders in a bank buy

shapes which then entitle them to dividends. The profitability of this investment is given by

the formula of the return on equity which is given as follows:

Because equity capital does not contribute to profits increasing it leads, ceteris paribus, a

decrease in the profitability of banks, making them less attractive in relation to other

investments. As individual banks will...need to attract investors more common-equity

investors than ever and those investors will demand a competitive rate of return 9 they

3N.M. The Economist Blog. Basel III

Third time's the charm?. Sep 13th 2010, 17:57.New York.

http://www.economist.com/blogs/freeexchange/2010/09/basel_iii .4

Ibid.,5

N.M. The Economist Blog. Basel III


http://www.economist.com/blogs/freeexchange/2010/09/basel_iii 6Ibid.,

7Anon. SEC criticizes rating agencies conflict of interest. Dealbook-New York Times.

http://dealbook.nytimes.com/2008/07/08/sec-criticizes-ratings-agencies-conflicts-of-interest/ 8

Paletta, Damien. Inching Toward World-Wide Accord on Bank Rules. Wall Street Journal. August 30 2010.New York.http://online.wsj.com/article/SB10001424052748703418004575455822415872894.html 9

N.M. The Economist Blog. Basel III
http://www.economist.com/blogs/freeexchange/2010/09/basel_iiihttp://www.economist.com/blogs/freeexchange/2010/09/basel_iiihttp://www.economist.com/blogs/freeexchange/2010/09/basel_iiihttp://www.economist.com/blogs/freeexchange/2010/09/basel_iiihttp://dealbook.nytimes.com/2008/07/08/sec-criticizes-ratings-agencies-conflicts-of-interest/http://dealbook.nytimes.com/2008/07/08/sec-criticizes-ratings-agencies-conflicts-of-interest/http://online.wsj.com/article/SB10001424052748703418004575455822415872894.htmlhttp://online.wsj.com/article/SB10001424052748703418004575455822415872894.htmlhttp://online.wsj.com/article/SB10001424052748703418004575455822415872894.htmlhttp://online.wsj.com/article/SB10001424052748703418004575455822415872894.htmlhttp://dealbook.nytimes.com/2008/07/08/sec-criticizes-ratings-agencies-conflicts-of-interest/http://www.economist.com/blogs/freeexchange/2010/09/basel_iiihttp://www.economist.com/blogs/freeexchange/2010/09/basel_iii


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might choose to meet new requirements by decreasing risk-weighted assets (i.e. loans) rather

than increasing equity capital. Additionally, the differential in profitability of banks with

higher capital rations is aggravated by tax law, the money banks spend on paying interest

rates for depositors is generally tax-exempt, however the money they spent on dividends is

generally not tax-exempt.10 For this reason higher capital rates are a more expensive source

of financing for banks than normal debt instruments and, consequently, banks lend less,

reducing growth.11

There are reasons to be sceptical about this, namely: the lack of empirical evidence of this

and the benefits that an economy gets from fewer bank collapses. The lack of evidence of a

link between growth and capital ratios is illustrated below:

Figure 1. Taken from the Bank of England12

We can see that there is no clear link...[between]..leverage (total assets relative to equity)

and GDP growth.13 The second issue is the stability that higher capital ratios bring by


http://www.economist.com/blogs/freeexchange/2010/09/basel_iii ,10

Herring, Richard J . Basel III: Banks Confront Complex Choices.

http://www.youtube.com/watch?v=pRSMYn2CU2s 11

Anon. The banks battle back. The Economist May 27th 2010 |

http://www.economist.com/node/16231434 12

Miles, David, Yang, Jing and Marcheggiano, Gilberto. Discussion Paper No. 31: Optimal bank capital. Bankof England: External MPC Unit.

http://www.bankofengland.co.uk/publications/externalmpcpapers/extmpcpaper0031.pdf
http://www.economist.com/blogs/freeexchange/2010/09/basel_iiihttp://www.economist.com/blogs/freeexchange/2010/09/basel_iiihttp://www.youtube.com/watch?v=pRSMYn2CU2shttp://www.youtube.com/watch?v=pRSMYn2CU2shttp://www.economist.com/node/16231434http://www.economist.com/node/16231434http://www.bankofengland.co.uk/publications/externalmpcpapers/extmpcpaper0031.pdfhttp://www.bankofengland.co.uk/publications/externalmpcpapers/extmpcpaper0031.pdfhttp://www.bankofengland.co.uk/publications/externalmpcpapers/extmpcpaper0031.pdfhttp://www.economist.com/node/16231434http://www.youtube.com/watch?v=pRSMYn2CU2shttp://www.economist.com/blogs/freeexchange/2010/09/basel_iii


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reducing bank crises massively overcompensates for any short-term losses. The BIS has

claimed the long-run benefits of these proposals arguably outweigh any marginal losses

incurred by the banking system or in fact society.14

The issues raised by this quote illustrate the diversity of opinions on the new set of proposals

to increase capital requirements. On the one hand, it goes a long way to mitigate the causes of

the liability side of the crisis but is disappointing in its disregard for the asset-side, in many

ways seen as the most crucial to the crisis, while maintaining the same incentive framework

that led us where we are today. On the other hand, there are arguments that this will actually

hamper already anaemic growth rates but could make up for it by a more stable system

overall. It should now be apparent that the answers to these two artificially divided questions

are actually intricately linked with the answer to one, being contingent on that of the other.

13Ibid.,

14Anon. Super Model. The Economist. August 19 2010.http://www.economist.com/node/16847862
http://www.bankofengland.co.uk/publications/externalmpcpapers/extmpcpaper0031.pdfhttp://www.bankofengland.co.uk/publications/externalmpcpapers/extmpcpaper0031.pdfhttp://www.bankofengland.co.uk/publications/externalmpcpapers/extmpcpaper0031.pdfhttp://www.bankofengland.co.uk/publications/externalmpcpapers/extmpcpaper0031.pdfhttp://www.bankofengland.co.uk/publications/externalmpcpapers/extmpcpaper0031.pdfhttp://www.bankofengland.co.uk/publications/externalmpcpapers/extmpcpaper0031.pdfhttp://www.bankofengland.co.uk/publications/externalmpcpapers/extmpcpaper0031.pdfhttp://www.bankofengland.co.uk/publications/externalmpcpapers/extmpcpaper0031.pdfhttp://www.bankofengland.co.uk/publications/externalmpcpapers/extmpcpaper0031.pdfhttp://www.bankofengland.co.uk/publications/externalmpcpapers/extmpcpaper0031.pdfhttp://www.bankofengland.co.uk/publications/externalmpcpapers/extmpcpaper0031.pdfhttp://www.bankofengland.co.uk/publications/externalmpcpapers/extmpcpaper0031.pdfhttp://www.bankofengland.co.uk/publications/externalmpcpapers/extmpcpaper0031.pdfhttp://www.bankofengland.co.uk/publications/externalmpcpapers/extmpcpaper0031.pdfhttp://www.bankofengland.co.uk/publications/externalmpcpapers/extmpcpaper0031.pdfhttp://www.bankofengland.co.uk/publications/externalmpcpapers/extmpcpaper0031.pdfhttp://www.bankofengland.co.uk/publications/externalmpcpapers/extmpcpaper0031.pdfhttp://www.bankofengland.co.uk/publications/externalmpcpapers/extmpcpaper0031.pdfhttp://www.bankofengland.co.uk/publications/externalmpcpapers/extmpcpaper0031.pdfhttp://www.bankofengland.co.uk/publications/externalmpcpapers/extmpcpaper0031.pdfhttp://www.bankofengland.co.uk/publications/externalmpcpapers/extmpcpaper0031.pdfhttp://www.bankofengland.co.uk/publications/externalmpcpapers/extmpcpaper0031.pdfhttp://www.bankofengland.co.uk/publications/externalmpcpapers/extmpcpaper0031.pdfhttp://www.bankofengland.co.uk/publications/externalmpcpapers/extmpcpaper0031.pdfhttp://www.economist.com/node/16847862http://www.economist.com/node/16847862http://www.economist.com/node/16847862http://www.economist.com/node/16847862


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Bibliography

Reports, Publications and Journal Articles

Miles, David. Speech entitled: Monetary Policy in Extraordinary Times.Centre for Economic Policy Research and London Business School. London.

23 February 2011.

Miles, David, Yang, Jing and Marcheggiano, Gilberto.Discussion Paper No. 31: Optimal bank capital. Bank ofEngland: External

MPC Unit.

http://www.bankofengland.co.uk/publications/externalmpcpapers/extmpcpape

r0031.pdf

Presentation/Lecture Videos

Herring, Richard J .Basel III: Banks Confront ComplexChoices.http://www.youtube.com/watch?v=pRSMYn2CU2s

News Articles, Special News Reports

Anon. SEC criticizes rating agencies conflict of interest. Dealbook-NewYork Times.http://dealbook.nytimes.com/2008/07/08/sec-criticizes-ratings-

agencies-conflicts-of-interest/

Anon. Super Model. The Economist. August 19 2010.http://www.economist.com/node/16847862

Anon. The banks battle back. The Economist. May 27th 2010 |http://www.economist.com/node/16231434

Conway, Edmunt.IMFputs total cost of crisis at 7.1 trillion.Telegraph.10:01PM 08 Aug 2009.

http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/5995810/I

MF-puts-total-cost-of-crisis-at-7.1-trillion.html
http://www.economist.com/node/16847862http://www.economist.com/node/16847862http://www.economist.com/node/16847862http://www.economist.com/node/16847862http://www.economist.com/node/16847862http://www.economist.com/node/16847862http://www.economist.com/node/16847862http://www.economist.com/node/16847862http://www.economist.com/node/16847862http://www.economist.com/node/16847862http://www.economist.com/node/16847862http://www.economist.com/node/16847862http://www.economist.com/node/16847862http://www.economist.com/node/16847862http://www.economist.com/node/16847862http://www.economist.com/node/16847862http://www.economist.com/node/16847862http://www.economist.com/node/16847862http://www.economist.com/node/16847862http://www.bankofengland.co.uk/publications/externalmpcpapers/extmpcpaper0031.pdfhttp://www.bankofengland.co.uk/publications/externalmpcpapers/extmpcpaper0031.pdfhttp://www.bankofengland.co.uk/publications/externalmpcpapers/extmpcpaper0031.pdfhttp://www.youtube.com/watch?v=pRSMYn2CU2shttp://www.youtube.com/watch?v=pRSMYn2CU2shttp://dealbook.nytimes.com/2008/07/08/sec-criticizes-ratings-agencies-conflicts-of-interest/http://dealbook.nytimes.com/2008/07/08/sec-criticizes-ratings-agencies-conflicts-of-interest/http://dealbook.nytimes.com/2008/07/08/sec-criticizes-ratings-agencies-conflicts-of-interest/http://dealbook.nytimes.com/2008/07/08/sec-criticizes-ratings-agencies-conflicts-of-interest/http://www.economist.com/node/16847862http://www.economist.com/node/16847862http://www.economist.com/node/16231434http://www.economist.com/node/16231434http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/5995810/IMF-puts-total-cost-of-crisis-at-7.1-trillion.htmlhttp://www.telegraph.co.uk/finance/newsbysector/banksandfinance/5995810/IMF-puts-total-cost-of-crisis-at-7.1-trillion.htmlhttp://www.telegraph.co.uk/finance/newsbysector/banksandfinance/5995810/IMF-puts-total-cost-of-crisis-at-7.1-trillion.htmlhttp://www.telegraph.co.uk/finance/newsbysector/banksandfinance/5995810/IMF-puts-total-cost-of-crisis-at-7.1-trillion.htmlhttp://www.telegraph.co.uk/finance/newsbysector/banksandfinance/5995810/IMF-puts-total-cost-of-crisis-at-7.1-trillion.htmlhttp://www.economist.com/node/16231434http://www.economist.com/node/16847862http://dealbook.nytimes.com/2008/07/08/sec-criticizes-ratings-agencies-conflicts-of-interest/http://dealbook.nytimes.com/2008/07/08/sec-criticizes-ratings-agencies-conflicts-of-interest/http://www.youtube.com/watch?v=pRSMYn2CU2shttp://www.bankofengland.co.uk/publications/externalmpcpapers/extmpcpaper0031.pdfhttp://www.bankofengland.co.uk/publications/externalmpcpapers/extmpcpaper0031.pdf


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N.M. The Economist Blog. Basel IIIThird time's the charm?. Sep 13th2010, 17:57.New York.

http://www.economist.com/blogs/freeexchange/2010/09/basel_iii

Paletta, Damien. Inching Toward World-Wide Accord on Bank Rules. WallStreet Journal. August 30 2010. New York.

http://online.wsj.com/article/SB1000142405274870341800457545582241587

2894.html
http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/5995810/IMF-puts-total-cost-of-crisis-at-7.1-trillion.htmlhttp://www.telegraph.co.uk/finance/newsbysector/banksandfinance/5995810/IMF-puts-total-cost-of-crisis-at-7.1-trillion.htmlhttp://www.telegraph.co.uk/finance/newsbysector/banksandfinance/5995810/IMF-puts-total-cost-of-crisis-at-7.1-trillion.htmlhttp://www.telegraph.co.uk/finance/newsbysector/banksandfinance/5995810/IMF-puts-total-cost-of-crisis-at-7.1-trillion.htmlhttp://www.telegraph.co.uk/finance/newsbysector/banksandfinance/5995810/IMF-puts-total-cost-of-crisis-at-7.1-trillion.htmlhttp://www.telegraph.co.uk/finance/newsbysector/banksandfinance/5995810/IMF-puts-total-cost-of-crisis-at-7.1-trillion.htmlhttp://www.telegraph.co.uk/finance/newsbysector/banksandfinance/5995810/IMF-puts-total-cost-of-crisis-at-7.1-trillion.htmlhttp://www.telegraph.co.uk/finance/newsbysector/banksandfinance/5995810/IMF-puts-total-cost-of-crisis-at-7.1-trillion.htmlhttp://www.telegraph.co.uk/finance/newsbysector/banksandfinance/5995810/IMF-puts-total-cost-of-crisis-at-7.1-trillion.htmlhttp://www.telegraph.co.uk/finance/newsbysector/banksandfinance/5995810/IMF-puts-total-cost-of-crisis-at-7.1-trillion.htmlhttp://www.telegraph.co.uk/finance/newsbysector/banksandfinance/5995810/IMF-puts-total-cost-of-crisis-at-7.1-trillion.htmlhttp://www.telegraph.co.uk/finance/newsbysector/banksandfinance/5995810/IMF-puts-total-cost-of-crisis-at-7.1-trillion.htmlhttp://www.telegraph.co.uk/finance/newsbysector/banksandfinance/5995810/IMF-puts-total-cost-of-crisis-at-7.1-trillion.htmlhttp://www.telegraph.co.uk/finance/newsbysector/banksandfinance/5995810/IMF-puts-total-cost-of-crisis-at-7.1-trillion.htmlhttp://www.economist.com/blogs/freeexchange/2010/09/basel_iiihttp://www.economist.com/blogs/freeexchange/2010/09/basel_iiihttp://online.wsj.com/article/SB10001424052748703418004575455822415872894.htmlhttp://online.wsj.com/article/SB10001424052748703418004575455822415872894.htmlhttp://online.wsj.com/article/SB10001424052748703418004575455822415872894.htmlhttp://online.wsj.com/article/SB10001424052748703418004575455822415872894.htmlhttp://online.wsj.com/article/SB10001424052748703418004575455822415872894.htmlhttp://www.economist.com/blogs/freeexchange/2010/09/basel_iii

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