The CumulaTive impaCT on The Global eConomy of · PDF fileGlobal eConomy of ChanGes in The...

September 2011

The CumulaTive impaCT on The Global eConomy of ChanGes in The finanCial ReGulaToRy fRamewoRk

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ii

This report presents the global financial services industry’s assessment of the net cumulative impact on economic activity of the widespread array of financial sector reforms proposed (and, increasingly, implemented) in the aftermath of the crisis that began in August 2007. It builds on the good work of the official and private sectors to explore these issues, and the analysis carried out by the IIF and its members over the past two years – work that was originally presented in an Interim Report in June 2010. The work was carried out under the auspices of the IIF’s Special Committee on Effective Regulation, and under the direction of the Institute’s Chief Economist and Deputy Managing Director, Philip Suttle.

The events of 2007-08 taught Industry participants, regulators, and other policymakers many painful lessons about the fault lines in the financial system. The financial sector has already taken steps to correct some of these issues. Other areas require the guidance that only globally coordinated regulatory change can deliver. Well-designed, appropriately sequenced, globally enforced regulatory reform measures will deliver long-run stability benefits that will be good for the global financial services industry and the global economy.

In the short term, however, the global economy is weak and is not well placed to handle the burdens imposed by the panoply of proposed measures that range from capital and liquidity to tax and structural change. If implemented on the time horizon currently envisaged, bank reform measures –

including the recent proposal for a capital surcharge on large financial firms – are likely to negatively affect global economic growth relative to what might otherwise prevail. There is, of course, no way of knowing for sure how these measures will affect the economy, and a wide array of outcomes is plausible depending on market responses. This study suggests, however, that the impact could total 3.2 percent of GDP over the next five years for the United States, Euro Area, Japan, United Kingdom and Switzerland. This would imply a combined 7.5 million jobs foregone in those countries alone.

The dilemma facing financial markets participants in both the official and private sectors is how to re-establish trust throughout the financial system, such that appropriate levels of credit growth can be restored to support economic growth and job creation. Regulatory reform plays an important role in this process, but it must be balanced: rigorous enough to ensure that the flaws revealed in 2007-08 are corrected (and new ones not allowed to develop); but calibrated to ensure that the financial sector does not over adjust and, in so doing, add a further painful, downward dynamic to the global economy.

We hope that this report will serve as a useful contribution to the achievement of this appropriate balance, and we look forward to continued dialogue on these important issues in the months ahead.

Josef Ackermann Chairman of the IIF Board Chairman of the Management Board and the Group Executive Committee Deutsche Bank

Charles Dallara Managing Director Institute of International Finance

Peter Sands Chair, IIF Special Committee on Effective Regulation Group Chief Executive Standard Chartered PLC

Philip Suttle Deputy Managing Director and Chief Economist Institute of International Finance

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ConTenTs

Preface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ii

IIF Board of Directors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

IIF Special Committee on Effective Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

Introduction and Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

Section 1: The Scope of Regulatory Change . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

Appendix 1.1: Specific Assumptions on Regulatory Reform used in the IIF Models . . . . . . . . . . . . . 27

Section 2: Progress to Date and Implied Distance to Adjust . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32

Section 3: A Framework to Assess the Costs Associated with Changes in the Financial Regulatory Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38

Section 4: The Key Role Played by Funding Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

Section 5: Estimating the Costs of Regulatory Reform: GDP and Employment Foregone . . . . . . . . 49

Appendix 5.1: Technical Details on Implementing Credit Tightening in NiGEM . . . . . . . . . . . . . . . . 59

Appendix 5.2: IIF Cumulative Impact Models: Country Results in Detail . . . . . . . . . . . . . . . . . . . . . . 60

Section 6: Assessing the Benefits of Regulatory Reform: Stability Prospects Improved . . . . . . . . . . 76

Section 7: Comparing the IIF Work with Studies from the Official Sector . . . . . . . . . . . . . . . . . . . . . 81

Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87

Other Useful References (not cited in the text). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91

IIF Macroeconomic Effects Working Group . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94

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insTiTuTe of inTeRnaTional finanCe boaRd of diReCToRs

Hassan El Sayed Abdalla Vice Chairman and Managing Director Arab African International Bank

Walter Bayly Chief Executive Officer Banco de Crédito del Perú

Martin Blessing Chairman of the Board of Managing Directors Commerzbank AG

Gary D. Cohn President and Chief Operating Officer The Goldman Sachs Group, Inc.

Yannis S. Costopoulos Chairman of the Board of Directors Alpha Bank A.E.

Ibrahim S. Dabdoub Group Chief Executive Officer National Bank of Kuwait

Charles H. Dallara (ex officio)Managing Director Institute of International Finance

Yoon-dae Euh Chairman and CEO KB Financial Group

Douglas Flint Group Chairman HSBC Holdings plc

James P. Gorman President and CEO Morgan Stanley

Oswald J. Gruebel Group Chief Executive Officer UBS AG

Jan Hommen Chairman of the Executive Board ING Group

Chairman Josef Ackermann

Chairman of the Management Board and the Group Executive Committee

Deutsche Bank AG

Treasurer Marcus Wallenberg Chairman of the Board

SEB

Vice Chairman Roberto E. Setubal

President and CEO Itaú Unibanco S/A and

Vice Chairman of the Board Itaú Unibanco Holding S/A

Vice Chairman Francisco González

Chairman and Chief Executive Officer

BBVA

Vice Chairman Rick Waugh President and

Chief Executive Officer Scotiabank

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Current as of august 2011

Jiang Jianqing Chairman of the Board & President Industrial and Commercial Bank of China

K. Vaman Kamath Chairman of the Board ICICI Bank Ltd.

Robert Kelly Chairman and Chief Executive Officer BNY Mellon

Walter B. Kielholz Chairman of the Board of Directors Swiss Reinsurance Company Ltd.

Nobuo Kuroyanagi Chairman The Bank of Tokyo-Mitsubishi UFJ, Ltd.

Frédéric Oudéa Chairman and Chief Executive Officer Société Générale

Vikram Pandit Chief Executive Officer Citigroup Inc.

Corrado Passera Managing Director and Chief Executive Officer Intesa Sanpaolo S.p.A.

Baudouin Prot Chief Executive Officer BNP Paribas Group

Urs Rohner Chairman of the Board of Directors Credit Suisse Group AG

Suzan Sabanci Dincer Chairman and Executive Board Member Akbank T.A.S.

Peter Sands Group Chief Executive Standard Chartered PLC

Yasuhiro Sato Chief Executive Officer Mizuho Financial Group

Martin Senn Chief Executive Officer Zurich Financial Services

Michael Smith Chief Executive Officer Australia and New Zealand Banking Group Ltd

James E. (Jes) Staley Chief Executive Officer Investment Banking J.P. Morgan

Andreas Treichl Chairman of the Management Board and Chief Executive Erste Group Bank AG

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Mr. David Hodnett Group Financial Director ABSA Group Limited

Mr. Bob Penn Partner Allen & Overy LLP

Ms. Alejandra Kindelán Oteyza Head of Research and Public Policy Banco Santander

Mr. Rob Everett European Chief Operating Officer Bank of America Merrill Lynch

Mr. Richard Quinn Director, Regulatory Affairs Barclays

Mr. Mark Harding Group General Counsel Barclays PLC

Mr. Gerd Häusler Chief Executive Officer Bayern LB

Ms. Maria Abascal Rojo Chief Economist – Regulation and Public Policy BBVA

The Honourable Kevin Lynch Vice-Chair BMO Financial Group

Mr. Christian Lajoie Head of Group Prudential Affairs / Co-head of Group Prudential and Public Affairs BNP Paribas

Mr. Baudouin Prot Chief Executive Officer BNP Paribas

Mr. Mark Musi EVP, Chief Compliance and Ethics Officer BNY Mellon

Mr. Brian Rogan Vice Chairman and Chief Risk Officer BNY Mellon

Ms. Jill Considine Chairman Butterfield Fulcrum Group

Ms. Jordi Gual Chief Economist CaixaBank

Mr. Michael Helfer General Counsel and Corporate Secretary Citigroup Inc.

Mr. Simon Gleeson Partner Clifford Chance

Dr. Korbinian Ibel Divisional Board Member GRM Risk Controlling and Capital Management Commerzbank AG

Dr. Stefan Schmittmann Chief Risk Officer and Member of the Board of Managing Directors Commerzbank AG

Dr. Rodney Maddock Executive General Manager Commonwealth Bank of Australia

Mr. Jérôme Brunel Head of Public Affairs, Member of the Executive Committee Crédit Agricole SA.

insTiTuTe of inTeRnaTional finanCe speCial CommiTTee on effeCTive ReGulaTion

Chairman Mr. Peter Sands

Group Chief Executive Standard Chartered, PLC

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Mr. Joshua Kaplan Crédit Agricole

Mr. Olivier Motte Head of Public Affairs Credit Agricole CIB

Dr. René Buholzer Managing Director, Global Head Public Policy Credit Suisse Group AG

Mr. Urs Rohner Chairman Credit Suisse Group AG

Mr. Robert Wagner Chief Analyst Danske Bank Group

Dr. Hugo Bänziger Chief Risk Officer and Member of the Management Board Deutsche Bank AG

Mr. Bjørn Erik Næss Chief Financial Officer DnB NOR ASA

Mr. Roar Hoff Executive Vice President, Head of Group Risk Analysis DnB NOR ASA

Mr. Wolfgang Kirsch Chief Executive Officer DZ Bank AG

Dr. Florian Strassberger General Manager DZ Bank AG

Dr. Manfred Wimmer Chief Financial Officer, Chief Performance Officer and Member of the Management Board Erste Group Bank AG

Mr. Barry Stander Head of Banks Act Compliance FirstRand

Mr. Faryar Shirzad Managing Director, Global Head Goldman Sachs

Mr. Gregory Wilson President Gregory P. Wilson Consulting

Mr. Santiago Fernandez de Lis Chief Economist on Financial System and Regulation Group BBVA

Ms. Maria Victoria Santillana Senior Economist – Regulation and Public Policy Group BBVA

Ms. Lara de Mesa Head of Public Policy Grupo Santander

Mr. Nasser Al-Shaali Chief Executive Officer Gulf Craft

Mr. James Chew Deputy Head, Strategy and Planning HSBC

Mr. Koos Timmermans Chief Risk Officer ING Group

Mr. Carlo Messina Chief Financial Officer Intesa Sanpaolo Spa

Mr. Roberto Setubal President and CEO of Itau Unibanco S/A and Vice Chairman of the Board of Itau Unibanco Holding S/A Itaú Unibanco S/A

Dr. Jacob Frenkel Chairman JPMorgan Chase International

Mr. Fernando Barnuevo Sebastian de Erice Managing Director Kleinwort Benson Advisers AG

Mr. Simon Topping Principal KPMG

Mr. Jonathan Gray Director of Regulatory Developments Lloyds Banking Group

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6 Mr. Peter Bethlenfalvy Senior Vice President Manulife Financial

Dr. Mark Lawrence Managing Director Mark Lawrence Group

Dr. Philipp Härle Director McKinsey & Company

Mr. Toshinao Endo Manager Mitsubishi UFJ Financial Group, Inc

Mr. Daisaku Abe Managing Executive Officer, Chief Strategy Officer and Chief Information Officer Mizuho Financial Group, Inc.

Mr. Frank Barron Chief Legal Officer Morgan Stanley

Ms. Candice Koederitz Managing Director and Global Head of Regulatory Implementation Morgan Stanley

Ms. Susan Revell Managing Director Morgan Stanley

Mr. David Russo Chief Financial Officer Morgan Stanley

Mr. Ibrahim Dabdoub Group Chief Executive Officer National Bank of Kuwait

Mr. Parkson Cheong General Manager and Group Chief Risk Officer National Bank of Kuwait, S.A.K.

Mr. Samuel Hinton-Smith Director, Public Affairs Nomura

Mr. David Benson Vice Chairman Nomura International plc

Mr. Ari Kaperi Executive Vice President, Chief Risk Officer Nordea Bank AB

Mr. John Drzik President and Chief Executive Officer Oliver Wyman

Mr. William Demchak Vice Chairman PNC Financial Services Group

Mr. Richard Neiman Vice Chairman PricewaterhouseCoopers LLP

Mr. Eugene A. Ludwig Founder and Chief Executive Officer Promontory Financial Group, LLC

Mr. Morten Friis Chief Risk Officer Royal Bank of Canada

Mr. Russell Gibson Director, Regulatory Affairs, Group Regulatory Affairs and Compliance Royal Bank of Scotland Group

Mr. Robert Pitfield Group Head, Chief Risk Officer Scotiabank

Mr. Nils-Fredrik Nyblaeus Senior Advisor to the Chief Executive Officer SEB

Mr. Pierre Mina Head of Group Regulation Coordination Société Générale

Mr. H. Rodgin Cohen Senior Chairman Sullivan & Cromwell LLP

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Mr. Nobuaki Kurumatani Managing Director Sumitomo Mitsui Banking Corporation

Mrs. Kerstin af Jochnick Managing Director Swedish Bankers Association

Mr. Philippe Brahin Managing Director Swiss Reinsurance Company Ltd

Mr. Donald Donahue President and Chief Executive Officer The Depository Trust & Clearing Corporation

Mr. Takashi Oyama Counsellor on Global Strategy to President and the Board of Directors The Norinchukin Bank

Dr. Steve Hottiger Managing Director & Head UBS AG

Mr. Sergio Lugaresi Senior Vice President Head of Regulatory Affairs UniCredit Group

Mr. David Zuercher Executive Vice President & Group Head Wells Fargo

Mr. Richard Yorke EVP and Group Head Wells Fargo & Company

Mr. Kevin Nixon Executive Director, Head of Regulatory Reform Westpac

Dr. Peter Buomberger Group Head of Government and Industry Affairs Zurich Financial Services

Dr. Madelyn Antoncic

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8

inTRoduCTion and summaRy

This report presents our updated assessment of the cumulative impact on economic activity of the widespread array of financial sector reforms proposed and, increasingly, implemented in the aftermath of the 2007–08 crisis. we hesitate to call it a “final” report, since both the regulations and our way of thinking about and modeling the impact of those changes are continuously evolving. we have benefitted from significant and regular interaction with other researchers, including many from the academic and official sector, and we have had the chance to compare and contrast our results with theirs – in the limited number of cases when the results have been made available.

Key meSSageS• The scope and magnitude of regulatory reform

facing the financial sector are very significant, affecting most aspects of financial firms’ behavior (see section 1, page 17). while supporting the need for reforms, we believe that further considerable attention should be given to their design. new reforms, which could add to the sizeable burden already in place, need to be carefully thought through, and the interplay of the proposed changes should be carefully evaluated.

• The economic impact of these reforms – in terms of real GDp and employment foregone –will be significant, and will be particularly felt over the next five years, as the system makes the bulk of its adjustment to new regulation. in our central estimate, which incorporates an assessment of the impact of a wide array of measures being taken at both the international and national level, we estimate that the level of real GDp in five years time will be about 3.2 percent lower than it would otherwise be (i.e., relative to our baseline scenario). This translates into a loss in output amounting to about 0.7 percent per year (see Table i.1, page 10 for a summary of our results; see section 5, page 49 for a more complete discussion). our estimates of the likely near–term costs associated with the current package of reform proposals remain well above those from official sector studies (see section 7, page 81). This lower path of output would lead to a lower path for employment. in our central

estimate, the level of employment in five years would be about 7.5 million below that prevailing in the base.

• This impact will be concentrated on the major mature economies, which already have a slow growth problem. in this sense, we are reiterating the key message from our Interim Report. indeed, in the year since that report, the mature economies have been consistently weaker than expected, and policymakers have been surprised and disappointed at the sluggishness of bank lending activity. aggregate bank credit to the united states, euro area and united kingdom fell by 0.5 percent in the year to June 2011, which is very disappointing two years into an expansion. To us, this weakness is no real surprise, and is indeed something of a warning of what lies ahead if a course of aggressive and restrictive bank reform is pursued. aggressive bank reform is almost certain to further intensify the de–leveraging process in the mature economies, which could add to, rather than reduce, economic instability. more de–leveraging and weaker growth will make the resolution of sovereign debt difficulties all the more challenging, especially in europe (see section 2, page 32).

• although we think the mature economies will be most affected, it is likely that emerging countries will also experience negative economic effects of both international and local regulatory reforms. They are likely to suffer from any economic contraction experienced by those mature economies to which they are connected via trade linkages; or from any potential reduction in financial flows from these countries induced by the more stringent regulation (e.g., the new liquidity requirements reducing the amount of trade credit granted).

• The precise way in which reforms will restrain the current expansion will heavily depend on two channels. first, there is the issue of how investors in bank funding instruments respond to the implications of tougher regulation. if equity investors were willing to supply more bank equity at a lower cost (reflecting greater security) and bank bond investors were equally prepared to supply more long–term debt at manageable spreads, then the negative growth implications of the capital and liquidity reforms

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1 for example, see haldane (2011).

could turn out to be modest. so far, however, capital markets in bank funding instruments are tending to do the opposite. Capital raising for banks, beyond retained earnings, has been very challenging over the past year. This accounts in part for the sluggishness in bank asset growth and, especially, banks’ recent desire to shy away from lending to more risky borrowers (e.g., households and small and medium–sized enterprises, see sections 3 and 4, pages 38 and 43, respectively). Going forward, the regulatory reforms faced by some of the traditional investors in banks’ funding instruments, such as the insurance sector, are likely to restrain their ability or willingness to fund banks to the extent required under the new bank capital rules (see iif 2011c). in our framework, the need to raise significant amounts of new equity and, to a lesser extent, long-term bond funding, is likely to put significant upward pressure on the marginal cost of bank funding, which will be passed through into potentially sharply higher bank lending rates.

• second, there is then the issue of how bank managers respond to that change in funding conditions. bank managers are likely to respond to higher funding costs in a variety of ways. They will try to cut other costs – most notably compensation, which we project to grow by between 3 and 5 percentage points less per year in our reform scenarios. but, in large part to satisfy the requirements of equity holders seeking an acceptable return on equity, most of these higher (marginal) funding costs will be passed through to borrowers in the form of higher (marginal) lending rates. banks are also likely to respond to higher capital and liquidity requirements in part by trimming risk assets. such additional de–leveraging is liable to exacerbate many of the pressures that have been painfully evident in recent months, whether these are disappointingly weak growth in lending to

small and medium–sized enterprises in the united states, or reductions in cross–border sovereign debt holdings within the euro area.

• broadly simultaneous imposition of these reforms amounts to the equivalent of all the major central banks in the world tightening at the same time. among the major central banks, there has been some inconsistency in the willingness to de facto tighten financial conditions through reform; to date, only the european Central bank has recently been willing to countenance formal monetary tightening. indeed, some policymakers are beginning to articulate the case that current macroprudential policy needs to be geared toward encouraging banks to add, not cut, risk assets.1

• There are, of course, benefits from the process of regulatory reform, which should accrue over the longer term. however, just as we believe that these official sector studies have tended to downplay the economic growth costs of reform, we also believe that these studies have tended to overstate its benefits. This is because the studies have concluded that reform would both bring about a larger decline in the probability of future crises and save more than we view as reasonable in terms of GDp forgone. The events of the past year – especially the sovereign debt crisis in parts of the euro area – serve to highlight that financial crises are apt to originate in sectors other than the banking sector. To be sure, more resilient banks would help stop the spread of difficulties that may originate in the government debt market. however, the fact that the epicenter of the euro area debt crisis is in the asset class – sovereign debt – that forms the fulcrum of the new global liquidity regime that is supposed to make banks far safer is a somewhat disconcerting reminder of the challenge to design reform measures that can assuredly deliver a safer banking system (see section 6, page 76).

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(a) Central scenario averages over 2011-13 not shown(b) Central scenario values for 2013 not shown

source: iif staff estimates.

Table I.1: IIF Cumulative Impact Results – Comparison of Scenarios (difference between relevant scenario and base scenario)

Central scenario Benign funding scenario Rapid adjustment scenario

Difference from Central

Difference from Central(a)Difference in annual avg. rates 2011–15 2011–15 2011–13

Real lending rate (bps)

United States 468 293 –174 701 246Euro Area 291 92 –199 304 125Japan 202 99 –102 266 118United Kingdom 548 106 –441 654 394Switzerland 93 40 –52 132 53G3 (GDP-weighted) 356 185 –171 478 179All countries above 364 177 –187 484 191

Real GDP growth (percentage points)

United States –0.6% –0.4% 0.2% –1.8% –0.5%Euro Area –0.6% –0.3% 0.3% –0.8% –0.2%Japan –0.8% –0.3% 0.5% –1.2% –0.1%United Kingdom –1.1% –0.3% 0.8% –1.8% –0.7%Switzerland –0.8% –0.1% 0.7% –1.1% –0.4%G3 (GDP–weighted) –0.6% –0.3% 0.3% –1.3% –0.3%All countries above –0.7% –0.3% 0.3% –1.3% –0.3%

Difference from Central

Difference from Central(b)

Difference in end pd. values

Through 2015

Through 2015

Through 2013

Core Tier 1 Capital ($ billion)

United States 161 161 0 205 117Euro Area 695 695 0 992 415Japan 166 166 0 166 90United Kingdom 226 226 0 236 98Switzerland 57 57 0 52 4G3 1,022 1,022 0 1,363 622All countries above 1,306 1,306 0 1,650 724

Real GDP (% difference)

United States –2.7% –1.8% 0.9% –5.2% –1.3%Euro Area –3.0% –1.4% 1.5% –2.2% –0.6%Japan –4.0% –1.7% 2.3% –3.6% –0.3%United Kingdom –5.5% –1.5% 4.0% –5.3% –2.0%Switzerland –3.7% –0.5% 3.2% –3.3% –1.3%G3 (GDP–weighted) –3.0% –1.6% 1.4% –3.8% –0.9%All countries above –3.2% –1.6% 1.6% –3.9% –0.9%

Employment (million)

United States –2.9 –1.1 1.8 –5.8 –1.4Euro Area –2.8 –1.2 1.6 –2.0 –0.7Japan –0.5 –0.2 0.3 –0.4 0.0United Kingdom –1.2 –0.3 0.9 –1.1 –0.5Switzerland –0.1 0.0 0.1 –0.1 –0.1G3 –6.2 –2.5 3.6 –8.2 –2.2All countries above –7.5 –2.9 4.7 –9.4 –2.7

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2 one effect that we have not fully been able to incorporate in our framework, and which may represent a downside risk to our estimates, is the potential impact of reforms on banks’ business models, especially if that resulted in tighter credit conditions for particularly vulnerable sectors.

CompariSon with our interim reportThe current report follows up on a number of pieces of work on this important area conducted at the institute of international finance (iif). it builds especially on our Interim Report on this subject, published in June 2010. Relative to that work, we have made the following changes:

• we now have a more complete picture of the likely process of regulatory change. The basel iii proposals on capital have been mostly finalized, although the liquidity proposals still need to be fully fleshed out. a wider array of international measures, such as systemically important financial institutions (sifi) surcharges, and national measures has been under advanced discussion in the past year.

• we have made efforts to improve our methodology and have benefitted from helpful comments and suggestions from analysts in both the private and official sectors. we are running three scenarios for each jurisdiction that reflect different capital market conditions for bank funding instruments (easy, moderate, and tough). we are now also using the national institute Global econometric model (niGem) of the uk’s national institute of economic and social Research (niesR) to map from the implied increase in bank lending rates and reduced credit supply to the private sector to broader GDp effects. This model has the major advantage of picking up far more behavioral interaction than our previous approach. it also allows us to indentify global interactions.

• This study covers five major financial sectors. we have added estimates on the united kingdom and switzerland to those of the united states, euro area, and Japan.

• we make some effort to compare costs versus benefits. in lining up costs versus benefits, it is important to recognize that everyone accepts that most of the costs will be borne in the near-term, whereas the benefits will be longer term in accruing. The analogy drawn is to that of an insurance contract: the buyers of a contract are willing to pay a regular, periodic premium in return for insurance to provide

against a sizeable but uncertain longer-term loss. but it is not clear that this is a policy that will deliver. furthermore, it is likely that more substantial benefits will come from other sources, particularly the implementation of effective macroprudential policies.

• The net impact of all these changes on the aggregate near-term results of our work is not that significant (see Table i.2, next page). for the G3 economies in aggregate, the reduction in growth that we envisage is similar now to what it was in our Interim Report, although there is some redistribution of the cost away from the euro area to Japan. in terms of what delivers this outcome, the magnitude of the changes in regulatory reform that are now foreseen over the next few years is greater than it was in our Interim Report, which hurts Japan, where capital raising for banks will be challenging. on the other hand, delayed and phased introduction of the basel iii measures is helpful in reducing our near-term cost estimates, especially in the case of the euro area. The amounts of bank capital to be raised in coming years are substantially higher, and they are liable to stress bank equity markets over the next few years. The relatively disappointing performance of bank equity prices over the past year is consistent with this more sober outlook.2 The switch to niGem also undoubtedly affects the assessed impact of changes in banking conditions on the broader economy. The model’s self-re-equilibrating properties are such that the negative impact of reforms on GDp growth does not persist for as long as it did in our Interim Report. of course, whether the real world currently exhibits such self-equilibrating properties is a little more questionable at the current time.

• The near-term (five years out) estimated employment losses are smaller than in our Interim Report, even though the GDp losses are broadly similar. This change reflects two main factors. first, the distribution of the output losses is now more biased toward countries with a lower employment-to-GDp elasticity (e.g., Japan). second, our new models mean that we are using slightly different employment-to-GDp relationships across all.

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Table I.2: IIF Cumulative Impact Results – Comparison of Current and Interim Reports (difference between core regulatory change and base scenario)

Current Report Interim Report Difference

Difference in annual avg. rates 2011–15 2011–20 2011–15 2011–20 2011–15 2011–20

Real lending rate (bps)

United States 468 243 169 136 299 107Euro Area 291 328 134 97 157 231Japan 202 181 76 60 126 121United Kingdom 548 568 … … … …Switzerland 93 40 … … … …G3 (GDP-weighted) 356 265 132 99 224 166All countries above 364 281 … … … …


United States -0.6% -0.1% -0.5% -0.3% -0.1% 0.2%Euro Area -0.6% -0.4% -0.9% -0.5% 0.3% 0.1%Japan -0.8% -0.3% -0.4% -0.1% -0.4% -0.2%United Kingdom -1.1% 0.0% … … … …Switzerland -0.8% -0.3% … … … …G3 (GDP–weighted) -0.6% -0.3% -0.6% -0.3% 0.0% 0.0%All countries above -0.7% -0.2% … … … …

Difference in end pd. values

Through 2015

Through 2020

Through 2015

Through 2020

Through 2015

Through 2020

Core Tier 1 Capital ($ billion)

United States 161 70 247 260 -86 -190Euro Area 695 386 273 738 422 -352Japan 166 173 156 169 10 4United Kingdom 226 111 … … … …Switzerland 57 77 … … … …G3 1,022 629 676 1,167 346 -538All countries above 1,306 816 … … … …

Real GDP (% difference)

United States -2.7% -1.1% -2.6% -2.7% -0.1% 1.6%Euro Area -3.0% -3.9% -4.3% -4.4% 1.3% 0.5%Japan -4.0% -3.4% -1.9% -1.5% -2.1% -1.9%United Kingdom -5.5% -0.5% … … … …Switzerland -3.7% -2.9% … … … …G3 (GDP–weighted) -3.0% -2.5% -3.1% -3.1% 0.1% 0.6%All countries above -3.2% -2.4% … … … …

Employment (million)

United States -2.9 0.9 -4.6 -4.9 1.7 5.8Euro Area -2.8 -4.0 -4.7 -4.8 1.9 0.8Japan -0.5 -0.4 -0.5 -0.4 0.0 0.0United Kingdom -1.2 -0.4 … … … …Switzerland -0.1 -0.1 … … … …G3 -6.2 -3.5 -9.7 -10.1 3.5 6.6All countries above -7.5 -4.1 … … … …


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there iS no right anSwerin addition to our core reform scenario, we also run two variants. The first is a benign funding scenario, in which we assume very elastic funding markets for banks – somewhat reminiscent of global conditions before mid-2007. The second is an accelerated adjustment scenario, in which we assume that changes programmed to occur by 2018-19 happen far more quickly. The most likely driver of such rapid adjustment would be market pressures.

The results of these variants are highlighted both in Table i.1 (page 10) and Charts i.1 through i.4 below. The

dispersion of the results in these scenarios is a reminder that there is no “right” or “wrong” answer to the question of what the near-to-intermediate costs of financial sector regulatory reform. in a scenario in which the measures are modest (e.g., just 2 percentage points on minimum core equity ratios) and funding markets for banks are elastic, implying that banks can raise new equity, at the margin, at very favorable terms, it follows that the near-term macroeconomic costs of reform are likely to be quite modest. at the other extreme, a wide array of changes carried out over a short time frame could produce quite a dislocation.

0

100

200

300

400

500

600

700

2010 2012 2014 2016 2018 2020

Rapid Adjustment Scenario

Central Scenario

Benign Funding Scenario

All Countries: Real Lending Rate basis point, difference from base

Chart I.1

-4.0%

-3.5%

-3.0%

-2.5%

-2.0%

-1.5%

-1.0%

-0.5%

0.0%

2010 2012 2014 2016 2018 2020

All Countries: Real GDP Level percentage difference from base


Central Scenario


Chart I.3

-2.0%

-1.5%

-1.0%

-0.5%

0.0%

0.5%

1.0%

2010 2012 2014 2016 2018 2020

All Countries: Real GDP Growth percentage point, difference from base



Central Scenario

Chart I.2

-10

-8

-6

-4

-2

0

2

2010 2012 2014 2016 2018 2020

All Countries: Employment Loss million, difference from base


Central Scenario


Chart I.4


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3 This is because we have been unable to obtain the necessary macro information on off-balance sheet commitments and derivatives. for a discussion of the implications of a leverage ratio regulatory limit see frenkel et al. (2010).

Computing these three variants across five countries also gives us a total of 15 scenarios. focusing on a single variable from each of these scenarios, we can plot a histogram that shows the distribution of that variable across the different scenarios. in the case of the level of real GDp, for example, the distribution in our work shows an average GDp decline of 2.6 percent by 2015 (see Chart i.5). This approach of averaging the results of studies using different methodologies across an array of economies was one adopted by the macroeconomic working Group of the financial stability board/basel Committee on banking supervision (fsb/bCbs), and the histogram approach thus gives us another way of comparing, and contrasting, the results of our work with that of the official sector (see Chart i.6 and section 7, page 81).

Differences in underlying economic conditions – especially in the context of market conditions for key bank funding instruments – can thus be critical in shaping the possible distribution of outcomes.

another way of conceiving differences in economic costs is to focus on differences in time horizon. most models – including our own – have the property that the economic costs associated with the regulatory reform process tend to go down over time. The longer the period of focus, the less the costs of reform are likely to be and, most likely, the higher the benefits. in large part, this is because the system benefits from an extended adjustment phase. one of our main concerns is that the transition costs are likely to be quite significant in coming years, as banks and markets focus on what needs to be done before 2014-15 in an environment of already weak economic activity and fragile, nervous financial markets. financial markets have a habit of being forward-looking, and investors will want to see that those banks that will need to satisfy capital and liquidity conditions in the next few years can indeed do so as soon as possible. This is liable to make banks very conservative and leery to lend to risky borrowers – or offer to lend to them at far higher rates – just at the very time when generalized global fiscal tightening in the major economies, ongoing extreme weakness in the housing market, and fears of a double-dip recession in the united states, and sovereign debt difficulties in the euro area are all creating a very adverse economic environment.

while we think that the results of our core regulatory reform scenario yield the most plausible assessment of the near-to-medium-term economic impact of reform measures, there are a number of possible reasons why our assessment could err on the optimistic side, and the economic cost of reform could thus be higher than we assess:

• in our modeling work, we do not consider the economic implications that could result from the introduction of the leverage ratio.3 The effects of the interplay of the leverage ratio with the liquidity ratios are not yet well understood, but may result in complex compliance problems that will affect banks' decision–making on business models.

• There are undoubtedly also other reform measures that could be restrictive, but which we have not been able to model appropriately. for example, we are unsure about whether we have captured the restrictive effects of the proposed new liquidity regime on trade finance. we also have not

0%

15%

30%

45%

-5% -4% -3% -2% -1% 0% 1% 2%

2015 2020

Percentage Difference from Base in Real GDP Frequency, 15 IIF Scenarios

Mean: -2.1% Mean: -2.6%

Chart I.5

0%

10%

20%

30%

40%

50%

-5% -4% -3% -2% -1% 0% 1% 2%

IIF 2015

BCBS 4YR

Percentage Difference from Base in Real GDP Frequency, comparison of IIF and BCBS scenarios

Chart I.6

source: bCbs (2010a) and iif staff estimates.


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incorporated the capital and liquidity implications associated with the move to central counterparty clearing in derivatives markets.

• our framework allows the pass-through from higher bank funding costs mainly to higher lending rates, with only modest effects imposed through credit restraint. The disruption resulting from less price pass-through and more credit restraint would be more severe. furthermore, internal pricing will also be affected, changing the allocation of resources within banks, although the exact dynamics of this process are still very uncertain.

• we also assume that liquidity requirements can be met largely through increased issuance. if higher liquid asset acquisition is assumed to displace other credit, then the economic dislocation could be, once again, more severe than in our core scenario.

There are also some reasons why our assessment could err on the pessimistic side:

• most importantly we could be taking too pessimistic a view on the availability of capital to banks and the terms on which investors will be willing to provide that capital.

• we may be overstating the impact of capital reforms. The new reforms mostly specify minimum requirements, generally leaving open for judgment what buffers national supervisors will choose to enforce.

• our work covers only five jurisdictions, which are likely to be the most affected by reform measures. although we have done detailed work on emerging europe (to be published separately), we have not attempted to cover other emerging economies. but we suspect that they will be less affected by the measures, implying a reduced hit to overall global growth.

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THE REPORT AT A GLANCE Key Messagessection 1 (pages 17–31) The Scope of Regulatory Change • The scope of regulatory change now underway is substantial. • The changes include a wide array of coordinated, international measures, as

well as many nation–specific changes.section 2 (pages 32–37) Progress to Date and Implied • banks are four years into what will be a protracted, decade–longDistance to Adjust phase of adjustment to tougher standards. • The distance remaining to adjust is substantial. • much of the adjustment to date has occurred through de–leveraging, which

has been bad for the global economy. section 3 (pages 38–42) A Framework to Assess the Costs • looking ahead, we assume that banks will re-price credit and reduce creditAssociated with Changes in the availability as their primary adjustment mechanisms to tighter standards.Financial Regulatory Framework • both credit re–pricing and reduction in credit availability will result from a

number of channels. section 4 (pages 43–48) The Key Role Played by • The terms on which equity and bond investors are willing to supply net Funding Costs new funding to banks are probably the key determinants of the macro-

impact of reform. • at issue is the relevance of the modigliani–miller theorem. we believe that

this is not a good description of the situation facing banks in the next few years. neither capital nor long–term debt will be cheap.

section 5 (pages 49–75) Estimating the Costs of • Tougher regulations will increase capital needs by $1.3 trillion andRegulatory Reform: long–term debt issuance by $0.3 trillion by 2015.GDP and Employment Foregone • These funding demands will lead to an increase in bank lending rates of about 364bps over the next five years. • higher lending rates will reduce the level of real GDp by about 3.2 percent

over the next five years, or by about 0.7 percent per year. • This would lead to about 7.5 million fewer jobs being created over the next

five years. section 6 (pages 76–80) Assessing the Benefits of • assessments of the benefits of reform turn on two key issues: how muchRegulatory Reform: Stability will reform reduce the likelihood of a future crisis? and how costly areProspects Improved banking crises? • we believe that official sector benefit studies overstate the case in both of

these areas.section 7 (pages 81–86) Comparing the IIF Work with • official sector studies generally downplay the macroeconomic costs ofStudies from the Official Sector regulatory reform. • This is because these studies do not incorporate the full array of reform

proposals and, in our view, are too sanguine about the funding implications.

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seCTion 1: The sCope of ReGulaToRy ChanGe

4 under the current proposals, such “gold-plating”of basel iii would only be allowed on a pillar 2 basis.

The scope of regulatory changes now underway in response to the 2007-09 financial crisis is substantial, involving significant amendments to rules governing bank capital, liquidity, the treatment of firms deemed to be systemic, resolution regimes, derivative markets, accounting, compensation, rating agencies and securitization (Table 1.1, next page).

many of the changes underway are beyond the scope of this study, although their full implementation is likely to imply significant costs to the global financial industry – costs that are likely to involve some combination of cost cutting elsewhere (including reductions in compensation costs), higher bank lending rates and other fees and charges, and lower bank earnings than would otherwise be the case. since our empirical work covers only a subset of the changes actually being implemented, our estimates might understate the macroeconomic impact resulting from the measures.

To make our empirical work tractable, we have narrowed the financial regulatory reform measures considered, and divided them into two groups (Chart 1.1):

• internationally agreed-on measures that largely reflect those agreed to as part of basel iii.

• national supplements, which reflect local policy priorities and preferences. it is important to

remember that basel iii (similarly to its predecessors) is designed to set international minimum standards, and countries have always been free to set and enforce local standards in excess of these international minima.4 post-crisis country-specific reforms extend well beyond setting such national buffers, however.

1.1 internationaLLy agreeD-on meaSureS

CapitalThere are four aspects to the more rigorous global capital regime that we assume in our analysis:

1a) higher core ratios. The new global regime governing the evolution of capital ratios that we apply to our models follows that specified in the basel iii agreements, published in December 2010. in this new regime, the emphasis will be on common, or core Tier 1, equity (we use these terms interchangeably). starting in 2013, the minimum common equity ratio will rise progressively from its current level of 2 percent of risk-weighted assets to reach 7 percent at the beginning of 2019 – a 5 percentage point rise (Table 1.2).

Globally Coordinated Reforms Distance for Banks to Adjust

Time Permitted for Implementation

National Idiosyncratic Reforms

Economy's Dependence on Banks for Credit Intermediation

Other Factors Shaping Banking Health

Impact on Economy

Chart 1.1 Schematic Outline of Differential Impact of Regulatory Reform

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1b) Redefinition of Capital. The emphasis on common equity in basel iii means that some of the components that are currently eligible to be counted as Tier 1 or Tier 2 capital will no longer be eligible for such treatment over time. as a result, the stock of Tier 1 equity will thus decline, and, all other things being equal, will need to be bolstered by new common equity issuance. additionally, a number of instruments with poor loss absorbing capacity will be disallowed over time from inclusion in either non-core Tier 1 or Tier 2 components of capital. There is a significant number of changes proposed under these redefinitions, but the most important are the treatment of:

• Minority interests. “minority interest” refers to third-party equity contributions to the subsidiary, that is, part of the subsidiary equity that is not owned by the parent company. under normal accounting rules, minority interest is included in the equity portion of the consolidated balance sheet. under basel iii, however, only the portion of minority interest that is necessary to meet the minimum capital requirement of the subsidiary is included in the consolidated capital.

• Investments in other financial firms. This refers to investments in the capital instruments of other financial institutions that are not consolidated

Capital

• New minimum capital levels• Capital conservation buffer• Counter-cyclical buffer• Revised definition of capital• Trading book capital• Counterparty credit risk charge• Contingent capital• Leverage ratio

Systemic Firms

• Defining systemic importance• Capital surcharges• Restructuring• Contingent capital• Levies/taxes

Derivatives

• Central clearing houses• Dealer regulation• Post-trade disclosure• Trading venue regulation• Collateral• Standardization

Securitization

• Capital requirements• Skin-in-the-game• Underwriting standards• Disclosure requirements

Rating Agencies

• Registration• Standards• Restricted use in regulation

Liquidity

• Liquidity coverage ratio• Net stable funding ratio• Liquid asset definition• Role of central bank• Local restrictions• Off-balance sheet commitments• Treatment of financial institutions• Money market fund regulation

Bank Resolution

• Bail in• Cross-border resolution• Recovery plans• Recovery fees, taxes and assessments• Restructuring

Compensation

• Guidelines on risk alignment and governance• Deferrals and claw-backs• Link to capital conservation• Limits for state-assisted firms• Shareholder say on pay

Accounting

• Global coordination and convergence• Loan-loss provisioning• Netting• Consolidation and de-recognition• Hedge accounting• Fair value measurement• Fair value versus accrual accounting• Financial statement preparation

Table 1.1: The Regulatory Agenda Facing Financial Firms

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for regulatory purposes. under basel iii, different treatment applies to significant investments in other financial institutions where the bank has more than 10 percent of the issued common share of the issuing entity.

• Pension fund assets. This refers to the difference between a bank’s defined benefit pension fund assets and its defined benefit pension obligation. under basel iii, this difference is to be deducted from common equity Tier 1. This is supposed to address the concern that assets arising from pension funds may not be capable of being withdrawn and used for the protection of depositors and other creditors of a bank.

• Deferred tax assets (DTAs). DTas are future tax assets that arise due to temporary differences in the accounting value and the tax value of assets and liabilities. under basel iii, those that will be deducted from capital are DTas that will be realized contingent on the future profitability of a bank. an example of this is when a bank has incurred a loss for financial reporting/accounting purposes but not for tax reporting purposes. The DTas that will arise in this case will only be realized through the reduction in future tax payments if the bank makes profits in the year that the loss is recognized for tax purposes.

• Mortgage servicing rights (MSRs). msRs are intangible assets held by banks acting as servicing agents for mortgage pools (such agents receive a fee, which together with the costs of providing the service, determine the value of the msRs). under basel iii, msRs of no more than 10 percent of a bank’s common equity can be counted, conditional

on further limit on the aggregate of the three items – msRs, DTas due to timing differences, and significant investments in common shares of unconsolidated financial institutions – subject to the “threshold” deduction. This restriction will mainly affect banks in the united states, where msRs are currently considered “qualifying” intangible assets that do not have to be deducted from Tier 1 capital.

The cumulative impact of these redefinitions will be significant. There are two sources of information that can be used to quantify their combined effect. first, the official sector has provided estimates, taken from its quantitative impact study, or Qis (see bCbs 2010e). a total of 263 banks from 23 Committee member jurisdictions participated in the Qis, which thus relates to far more jurisdictions than covered by our study. banks domiciled in the five jurisdictions covered in our survey accounted for 68 percent of this total – euro area (131), Japan (16), switzerland (8), the united kingdom (11), and the united states (13). unfortunately, the details of the impact of capital redefinitions were provided only in the aggregate. for large banks (banks with Tier 1 capital in excess of €3 billion), the implied reduction in common equity (based on end-2009 data) was 41.3 percent. for smaller banks, the implied reduction in common equity (2009 data) was 24.7 percent. assuming that these ratios apply to each of our jurisdictions and that large banks account for about 60 percent of total core equity, the implied absolute redefinition effects – in terms of core equity reductions that will need to be offset by the issuance of net new core Tier 1 equity, or the retention of an equivalent amount of profits – are shown in Table 1.3.

Table 1.2: Basel III Minimum Capital Ratios and Phase-in Plans All dates as of January 1st

2011 2012 2013 2014 2015 2016 2017 2018 2019

1. Minimum Common Equity Capital Ratio

2% 2% 3.5% 4% 4.5% 4.5% 4.5% 4.5% 4.5%

2. Capital Conservation Buffer 0.625% 1.25% 1.875% 2.5%

3. Total (1+2) 2% 2% 3.5% 4% 4.5% 5.125% 5.75% 6.375% 7%

4. Phase-in of deductions from core Tier 1 equity due to capital redefinitions

20% 40% 60% 80% 100% 100%

5. Phase-out of instruments that non longer qualify as non-core Tier 1 or Tier 2 capital

10% 20% 30% 40% 50% 60% 70%

Memo:Minimum Tier 1 Capital 4% 4% 4.5% 5.5% 6% 6% 6% 6% 6%Minimum Total Capital 8% 8% 8% 8% 8% 8% 8% 8% 8%

bCbs (2010a and 2010b).

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The combined total is a breathtaking $1.2 trillion of new capital required, or about 35 percent of core Tier 1 equity.

a second source is industry estimates, generally made by analysts looking at a relatively narrow set of banks, that is, mainly banks that would be part of the large banks covered by the basel Committee Qis. The advantage of this source is that the data are available more explicitly on a country-by-country basis. The disadvantage is that they relate to a relatively narrow set of large institutions, rather than the system as a whole. The results of the studies that we have collected are shown in Table 1.4.

in comparing the two measures, it is clear that the data implied by the bCbs Qis study are larger, especially for the euro area and united states. To take into account the features of the two sets of estimates, we decided to opt for a weighted average of the two estimates for each jurisdiction – 75 percent weight

attached to the industry estimate and 25 percent weight attached to the Qis results. This amount is then used as the stock of capital to be replaced by either new core Tier 1 market issuance or retained profits in five equal installments over the period 2014-18, according to the schedule set out in Table 1.2 above.

1c) Changes in Risk-weighting. There are a number of risk-weighting adjustments that will affect jurisdictions in the coming years. The most important of these are the changes that are being called “basel 2.5” – the changes in risk-weights to be applied to trading book assets. in our analysis, we assume that these risk-weightings rise approximately four-fold. based on industry analysis that we have seen applied to the large banks, this would also seem to be quite a conservative assumption. This increase in risk-weightings has the arithmetic effect of raising risk-weighted assets and, thus, lowering realized capital ratios.

Table 1.3: Impact of Redefinition Effects on Tier 1 Capital Requirements: BIS QIS Estimates

United States Euro Area Japan United Kingdom Switzerland

Tier 1 Capital (2009) $994 billion €1,443 billion ¥35 trillion £313 billion CHF145 billion

Implied reduction (60%*41.3% + 40%* 24.7%)

$345 billion €500 billion ¥12 trillion £108 billion CHF50 billion

sources: bCbs (2010e) and iif staff estimates

Table 1.4: Impact of Redefinition Effects on Core Tier 1 Capital Requirements: Industry estimates

United States Euro Area Japan United Kingdom Switzerland

JP Morgan (2010a) Sample of 12 large banks $140 billion

JP Morgan (2010b) Sample of 5 large banks $118 billion (£73 billion)

Sample of 2 large banks $21.2 billion (CHF 21.6 billion)

Credit Suisse (2010) Sample of 28 large banks €146 billion

Sample of 5 large banks €50 billion(£44 billion)

Morgan Stanley (2010) Sample of 26 large banks €149.2 billion

Sample of 5 large banks €71.8 billion(£64 billion)

Sample of 2 large banks €14.8 billion (CHF 22 billion)

Fitch Ratings (2009) Sample of 6 large banks ¥12 trillion

Average $140 billion €147.6 billion ¥12 trillion £60 billion CHF 21.8 billion

sources: industry estimates, see above.

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5 see, for instance, the discussion in Gauthier et al. (2010).6 The basel sib (systemically important bank) surcharge proposal relies on a range of criteria for assessing the degree of systemic importance of banks

and, consequently, for deciding the capital surcharge.7 supervisors typically require actual capital ratios to substantially exceed minimum requirements. for the liquidity ratios, it is unclear what buffers

regulators (or capital markets) will require.8 in both measures, sovereign debt holdings receive favorable weights (100% in the lCR and 5% in the nsfR), providing an incentive for banks to increase

their exposure to sovereign debt. The ongoing european sovereign debt crisis may cast some doubt on the suitability of the treatment of government debt as an appropriate funding instrument for banks. see Glionna and Crivelli (2010) and Committee on the Global financial system (CGfs) (2011b).

1d) Capital surcharges. The capital ratios specified in Table 2 are explicitly conceived of as minima. national regulators have been free, and will remain so, to impose national and bank-specific buffers as they see fit. in our projections, we assume that the buffers that have been in force in recent years are maintained at the same rates in the years ahead, although these nation-specific buffers in our regulatory reform scenarios are reduced commensurately with the capital conservation buffer after its introduction in 2016. on top of this nation-specific buffer, however, there are two internationally conceived capital buffers, or surcharges, that have been proposed and are likely to become part of the regulatory landscape in the years ahead. first, a countercyclical buffer has been proposed as a key part of the macroprudential landscape (see bCbs 2010c). although this buffer – amounting to somewhere between 0 percent and 2.5 percent of risk-weighted assets – is due to be introduced later in the decade, our projections show that it will most likely not be a binding constraint in the five jurisdictions covered in this study. second, and more significant, proposals for surcharges on sifis have been issued.5 our framework allows us to implement only a simplified version of the basel proposed “bucket” framework: we assign a capital surcharge to national SIFIs (i.e. banks large by national standards) which depends on their degree of SIFIness assessed in terms of assets’ size only.6 for switzerland, we implement the surcharge already agreed on.

Liquiditybasel iii introduces for the first time a rigorous global liquidity standard. There are two important components to this standard.

2a) liquidity Coverage Ratio (lCR). The lCR is a stock-flow ratio designed to test whether a bank can withstand a phase of liquidity stress. in the current designation, the scenario is envisaged to be a period of stress lasting 30 days. The lCR is formally defined as:

stock of high-quality liquid assets

Total net cash outflows over the next 30 calendar days

an observation period for this ratio has already begun (1 January 2011), and it will extend for four years. from 1 January 2015, banks will be required to maintain this ratio at or above 100 percent.7

The numerator – the stock of high-quality liquid assets – is split into two components: level 1 assets which are the highest quality assets and are not subject to haircuts. These assets are limited to central bank reserves and government debt. level 2 assets are subject to a haircut and may comprise no more than 40 percent of the required stock, and can include other high-quality securities, such as corporate bonds and covered bonds.

The denominator – total net cash outflows over the next 30 days – is calculated by comparing the amount of outflows that could occur – using specific (and seemingly quite conservative) assumptions about run-off and draw-down rates – with the amount of cash that the bank might be able to realize, excluding any sale or repo of assets included in the numerator.

2b) net stable funding Ratio (nsfR). The nsfR is designed to promote more medium-term and long-term funding of the assets and activities of banking organizations. The nsfR is formally defined as:

available amount of stable funding

Required amount of stable funding

an observation period for this ratio has already begun (1 January 2011) and it will extend for seven years. from 1 January 2018, banks will be required to maintain this ratio at or above 100 percent. “stable funding” is defined as the portion of those types and amounts of equity and liability financing expected to be reliable sources of funds over a one-year time horizon under conditions of extended stress.

The numerator – available stable funding – is calculated by taking key components of the liability side of a bank’s balance sheet and multiplying it by available stable funding (asf) factors. Capital, for example, gets a 100 percent asf weighting, as does long-term debt. Retail deposits attract a 90 percent asf weighting.

The denominator – required stable funding – is calculated by taking key components of the asset side of a bank’s balance sheet and multiplying it by required stable funding (Rsf) factors. The more liquid an asset, the lower the weight is attracts. Cash, for example, has a 0 percent weight, whereas long-term corporate loans attract a 100 percent weight.8

* * * *

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9 see Tarullo (2008).10 The attitude of the Japanese authorities appears to reflect the lessons learned from the Japanese financial crisis of the 1990s. see ito and sasaki (1998),

oyama and shiratori (2001), loukoianova (2008), brana and lahet (2009) and nakaso (2010).11 for the full act, see www.sec.gov/about/laws/wallstreetreform-cpa.pdf12 by 21 July 2011, less than 20% of the 243 rules included in the act have been completed.13 The base for the fee has recently been changed to total assets, shifting the burden to larger banks. This could potentially duplicate the effect of the sifi

surcharge.

There is regular and often heated discussion within the industry as to whether basel iii will be implemented and, if so, on what timetable. The main focus of such discussion is the united states, which failed to implement basel ii on a timely basis.9 it should be remembered, however, that the main reason that the us regulatory authorities failed to implement basel ii was that they felt it would lead to an undue easing in standards. Those same authorities – most notably the federal Deposit insurance Corporation (fDiC) – seem to have fewer concerns about basel iii. That said, however, the us authorities take the view that basel regulations are applicable only to internationally-active banks. and the focus on drafting and implementing local rules (shaped by the Dodd-frank legislation – see below) means that nation-specific measures are very important and, where in conflict with basel rules, liable to dominate them in the years ahead.

1.2. nation-SpeCifiC meaSureSThere are nation-specific measures that we judge to be sufficiently important in four out of the five jurisdictions that we cover in this study. The exception is Japan, where we assume that the authorities will focus on the full implementation of the basel iii reforms along the internationally agreed-on timeline.10

united StatesThe main regulatory response to the crisis in the united states has been a large act of Congress (h.R. 4173) that is commonly known as the “Dodd-frank act”, after its two main sponsors.11 The published act is 848 pages in length and, even then, largely amounts to a blueprint for reform. General requirements from the act are now in the process of being specified. as a result, we cannot be sure of how the specifics of the reform will play out.12 based on the state of play to date, however, we judge that the following aspects of the reform program are most relevant:

• Capital Ratios. The Collins amendment to the act sets a floor on banks’ capital ratios, requiring that risk-based capital may be no less than “generally applicable risk-based capital requirements”, currently standing at 6 percent in terms of Tier 1 capital to risk-weighted assets (Rwas) and 10 percent in terms of total capital to Rwas. The first

of these ratios broadly matches the requirements of basel iii (see Table 1.2, page 19), but the overall 10 percent minimum (to be binding in July 2015) is 2 percentage points higher than the basel iii minimum. in our framework, we translate this requirement into a national capital buffer enforced by the myriad of us bank regulators that is two points higher in the regulatory reform scenario than in the no reform scenario – an additional buffer that is phased in over 2012-14.

• Definition of capital. under Dodd-frank, redefinition effects are a little more rigorous than what the european Commission is currently proposing for european banks. most notably, hybrid instruments, such as qualifying cumulative perpetual preferred stock; minority interests; qualifying trust preferred securities and subordinated debentures issued to the Treasury Department as part of the TaRp (Troubled asset Relief program), cannot represent more than 25 percent of Tier 1 capital. Deductions of existing hybrid instruments from Tier 1 capital and consequent inclusion in Tier 2 are to be phased in over four years, from 2013 to 2016 for existing hybrid instruments, while instruments issued after may 2010 are only to be included in Tier 2. we estimate that these changes could boost overall cumulative redefinition effects, as well as bring forward their implementation somewhat.

• Additional taxes, fees and costs. banking sector profits will be squeezed to the tune of about $10 billion from three directions. This would amount to about 12 percent of 2010 aggregate post-tax profits of the sector.

- There is a significant hike in fDiC insurance fees that, we assess, will add 10 basis points to retail deposit costs, equivalent to about $6 billion.13

- The act sets higher fees to be charged by both the security and exchange Commission (seC) and federal Reserve. we assess that these would combine to about $1 billion per year and would be added to banks’ non-interest costs.

- banks’ own regulatory compliance costs will rise steeply. banks are expected to see an increase in their costs as they make infrastructure investments required to meet new legal and compliance procedures, including stress tests

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14 see standard&poor’s (2010).15 see krishnamurthy (2010) for a discussion of the performance of debt markets during the 2008-09 crisis.16 These powers are in line with those predicated in the recent proposals issued by the fsb and bCbs (2011).17 whether these provisions are credible is a subject of debate, but it is clear the banking authorities and rating agencies are taking them seriously.18 Rating agencies have recently issued reports on possible banks downgrade because of the loss of implicit government support. see moody’s (2011).

and new resolution regimes such as living wills. one additional cost is that Dodd-frank requires regulators to remove by July 2011 all references to credit ratings of securities from the rules. The requirement opens a conflict with basel iii, which assigns capital charges to securities depending on their rating. The act does not specify what alternative to rating agencies banks should use. The seC has begun a consultation process on the design of alternatives, expected to be completed by mid-2012. one possibility, however, is that banks will need to conduct their own analysis and assessment. standard&poor’s (s&p) expects these higher compliance costs to subtract about $3 billion from annual pre-tax earnings, while also emphasizing that this could be a conservative estimate.14 note that in this impact assessment we have not made any allowance for an additional bank tax such as a “financial Crisis Responsibility fee”. such a fee was originally part of the 2011 budget, and was to be levied as a tax on large firms amounting to 0.15 percent of total liabilities, to be applied for 10 years or longer until TaRp funds had been recouped – at this rate and level of incidence, it would have raised about $10 billion annually. a revised fee, expected to raise about $3 billion per year, has been proposed as part of the president’s 2012 budget, but, at the time of writing, its Congressional passage remains highly questionable.

• Restrictions on activities. The act imposes certain restrictions on bank activities, which are liable to reduce bank profitability. Three stand out as important:

- The Durbin amendment instructs the federal Reserve to issue rules to limit the fees that banks can charge on debit card transactions (“interchange fees”). The rules, which became effective in april 2011, will reduce fee income for banks by about $15 billion per year, although banks are liable to react to these changes by raising other fees and charges.

- The act limits banks’ derivatives activities. it requires all swap transactions to be performed through a clearinghouse. speculative-grade CDs, commodities and equity-related swaps are to be capitalized and traded through nonbank affiliates. however, banks retain the possibility to deal in safer instruments such as interest rate and foreign exchange derivatives and CDs on investment-grade

bonds, as well as gold and silver. The timetable is still uncertain. s&p (2010) estimates that the annual aggregate impact on pre-tax earnings could be in the range of $5-$6 billion per year.

- finally, there is the restriction that has become known as the Volcker Rule. This Rule (the specifics of which are currently being written) prohibits banks from engaging in proprietary trading, defined as any activity in which the bank is the principal in a transaction involving buying or selling of any security, derivative, or financial instrument. market making activities, in which the bank takes an inventory position on behalf of its clients, are not excluded. investments in private-equity or hedge funds are limited to 3 percent of the fund’s ownership and 3 percent of Tier 1 capital. The Rule becomes effective in 2014, following a two-year transition period, although extensions are possible. in our framework, the Rule could exert a restraining influence through two channels. first, it will likely further dampen bank earnings – possibly to the tune of $3.5-$4 billion a year – which will add to the pressures on bank lending spreads. second, and possibly more important, it could reduce the availability, and raise the cost, of debt intermediation through non-bank channels, which has typically been quite important to the us economy. it remains to be seen what impact the actual volcker Rule will have on the liquidity of debt markets.15 in our work, however, we have assumed that the volcker Rule will lead to an increase in the cost of non-bank debt finance to the private sector of 50 basis points.

• Resolution regime. The act gives the fDiC new "orderly liquidation authority”, that is the power to resolve non-bank financial institutions, therefore allowing intervention that would supersede the bankruptcy Code, adding to its longstanding powers to resolve insured banks.16 The act furthermore forbids the use of taxpayer funds to bail out individual institutions, as was done several times in the crisis.17 These changes are part of the global regulatory shift toward new resolution techniques, including "bail-in" and contingent capital in certain circumstances, and are generally welcomed. in our framework, we assume that these changes will raise large banks' wholesale funding costs by 100bps.18

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19 This is in contrast to the united states, where the basel iii rules are likely to be applied only to “internationally active” banks, and where the capital and other rules in the Dodd-frank act are not necessarily written to be congruent with the basel iii rules. Recent press reports have raised the question of whether there will be a “two-speed” adoption of basel iii rules within the european union – a suggestion that eu officials have vigorously denied.

20 Directive and Regulation proposals were published by the european Commission on July 20, 2011. These are intended to replace the current CRD (2006/48 and 2006/49). see european Commission (2011b).

21 in addition to these measures, the December 2010 final text of basel iii states capital incentives (low risk weights) for banks aimed at encouraging derivatives trades to be passed through clearing houses.

22 similar securitization reforms have been implemented in the united states and we assume a similar impact on funding costs.23 see european Commission (2007) and CGfs (2011a).

euro areaThe european union (eu) will adopt the basel iii package of reforms to be applied to all banks in all countries in the union19 as part of an updated Capital Requirements Directive (CRD iv).20 There are a number of directions in which euro area regulatory officials have taken actions to extend regulations beyond those currently specified in the basel rules. for example, the eu has adopted strict limits on compensation. it is hard to model the macroeconomic impact of such moves. by restraining the growth of non-interest costs, they could be helpful since they would presumably allow banks to raise earnings and thus generate capital more quickly. on the other hand, they might well put european financial institutions at a competitive disadvantage, thus damaging bank profitability. notable changes to basel iii included in the CRD iv proposals include regulation alongside directives, at the scope of limiting gold-plating, and a certain relaxation, mainly in terms of the timing of implementation, of the liquidity requirements.

among those measures for which there is a little more clarity, however, five stand out:21

• Securitization rules. article 122a of Directive 2006/48/eC introduced, among other things, a 5 percent risk retention requirement applicable to eu-regulated credit institutions that invest in securitization transactions, or that are exposed to credit risk of a securitization. eu member states had to implement this provision into national laws by the end of 2010. article 122a applies to eu credit institutions. however, consolidated regulatory supervision may have the effect of extending it to non-eu subsidiaries of eu credit institutions. Therefore, it is likely to have a global impact for eu regulated institutions as well as for originators and issuers looking to access these institutions as investors or as transaction counterparties. while these provisions have the advantage of forcing originators to keep their “skin in the game”, this is achieved through a mechanism that increases the costs of the securitization process and institutions’ cost of funding. in fact, the degree of risk retention, having resulted more from a political negotiation than from a comprehensive impact assessment, appears at this stage arbitrary. moreover,

the fact that it is determined through a legislative provision introduces an element of rigidity that - should the need arise in light of concrete application or market conditions - will make any recalibration of the requirement very difficult. in our work, we assume that this factor (among others) will raise the cost of debt intermediation through non-bank channels.22

• Higher taxes on bank earnings. Three governments – austria, france and Germany – have implemented higher specific taxes on bank earnings in addition to normal corporate taxes, and tax proposals have been outlined in portugal. measures announced to date add up to an additional annual tax burden of about €3 billion.

• Solvency II. starting January 2013, european insurers will be subject to this new risk-based capital framework, which will make it much more challenging for insurance companies to fund banks in both equity and long-term debt markets, reducing the role of insurers and their $22 trillion assets in the market for bank paper.23 in particular, it will provide substantial disincentives in the form of higher risk-weights to insurance companies in respect to the holding of certain securities such as corporate bonds, while adding to the demand for high-quality instruments. indeed the regime strongly incentivizes the holding of sovereign debt, especially european union sovereign debt, and covered bonds over unsecured corporate bonds. within the corporate bond universe, capital charges would drastically increase as duration increases, discouraging insurers from holding long term bank debt. This is likely to reduce insurers’ involvement in markets for Tier 1 and Tier 2 capital instruments at a time when banks need to issue new securities to meet the updated basel iii definition of capital and increase the maturity of their debt to comply with the nsfR.

• Resolution Regimes. similarly to the united states, frameworks for an effective resolution of banks in crisis, particularly systemically important ones, are currently in discussion in europe. The european Commission is expected to present its proposal for a resolution framework for eu banks in the summer of 2011. The framework, which will be supervised by

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24 see iif (2011b) and fsb (2011). Despite the already lengthy debate, there continue to be significantly different opinions about how resolution should work; how it can be organized on a cross-border basis; what “bail-in” techniques should be used, and what might be the appropriate role of contingent capital.

25 in 2009, the uk fsa initiated a consultative process on a number of proposals for strengthening financial regulation in the aftermath of the crisis. see fsa (2009a,b,c,d,e).

26 in the light of the proposed CRD iv liquidity regulation, it is unclear if uk regulators will be able to adopt these rules.27 see independent Commission on banking (2011). a final version of the report was released after publication of this study.28 see her majesty’s Revenue and Customs (hmRC) (2010).

the newly created european banking authority, is expected to include a mandate for firms to prepare and maintain detailed recovery and resolution plans. each jurisdiction is expected to be required to identify resolution authorities with clear resolution tools and powers to be adopted when a certain institution is failing or likely to fail. Resolution tools are likely to include: sale of business, transfer of business to a bridge bank, asset separation, and debt write-downs or conversion.24

• Restrictions on foreign currency lending in Emerging Europe. although these restrictions apply to banking systems in emerging europe, these regulations are liable to reduce the profitability of banking systems in the euro area that have significant retail exposures in emerging europe (e.g., austria and italy).

united Kingdom25

as an eu member, the united kingdom will have to adopt the “regulation” parts of CRD iv. however, it is also reserving the right to go further, for example with the use of macroprudential tools including additional capital requirements and higher risk-weights. in particular, there are three other local measures that need to be considered.

• The UK Financial Services Authority’s liquidity regime. in october 2009, the uk financial services authority (fsa) issued a set of liquidity rules to be implemented by 2010. following issuance of similar rules by the bCbs, the fsa has subsequently decided to abandon implementation. however, it still requires firms to produce an internal liquidity adequacy assessment and hold a liquid assets buffer calibrated on the basis of a supervisory approved process that includes stress testing. furthermore, a narrower definition of high-quality liquid assets is going to be used by uk regulators with respect to the lCR requirement, namely one that excludes highly rated corporate bonds and securities, differently from basel iii.26 finally, the fsa requires that liquidity regulation is applied to each operating entity rather than on a consolidated basis.

• The Vickers’ Report. The main relevant recommendation of the preliminary version of the Report is for universal banking groups to ring-fence retail and wholesale/investment activities

into separately capitalized subsidiaries.27 The Report recognizes the efficiency gains provided by universal banks which makes ring-fencing preferable to full Glass-steagal–type separation. This compartmentalization would ensure that, were a bank to encounter difficulties, the retail arm could be saved and the investment arm allowed to fail. The Report recommends that banking groups adhere to the minimum capital requirements set out by basel iii. but the Report also suggests that the basel iii 7 percent core Tier 1 minimum would not be sufficient. it recommends that the minimum should be supplemented with a sifi surcharge of at least 3 percent for the retail part of the bank, while it could be lower for the wholesale investment part, possibly in line with the bCbs decision on the level of sifi surcharges. Capital could be moved intra-group, conditional to the respective minimum standards being maintained by the two subsidiaries of the group.

• Bank levy. in the June 2010 budget, the newly elected Coalition Government announced the introduction of a “bank levy” from January 1, 2011.28 The levy is intended to incentivize banks to increase their Tier 1 capital, longer-term funding, retail deposits and liquid assets holding. The levy is imposed on the global consolidated balance sheet of uk banking groups and building societies, on proportion of the balance sheets of foreign banks operating in the united kingdom, on the uk banking component of non-banking groups and on uk banks that are not part of a group. The levy is applied to total chargeable equity and liabilities, excluding Tier 1 capital; retail deposits covered by deposit insurance or government guarantees; liabilities arising from insurance business within banking groups; tax liabilities; and offsetting high-quality liquid assets and repo liabilities secured against sovereign and supranational debt. The levy rate is set at 0.05 percent for 2011, rising to 0.075 from 2012 on short-term liabilities. long-term liabilities bear half that rate. The first £20 billion of eligible liabilities are exempt. The exemption has to be composed of both short and long term liabilities according to their proportion in the total of the eligible liabilities. hmT (her majesty’s Treasury) estimates that many of the uk banks and building societies do not breach the £20 billion liabilities threshold and that the levy will only affect between 30 and 40 firms.

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29 see swiss expert Commission (2010).30 in other jurisdictions, this would be called a sifi surcharge.31 in march 2011, the swiss regulator financial market supervisory authority (finma) announced pillar 2 requirements for non-sifis. The new

requirements have come into effect from July 2011, although they need to be met by 2016. The non-sifis are to be subject to different capital minima depending on their size and complexity. non-sifis are to be divided into four categories with minimum requirements ranging from 10.5% for the smallest and simplest banks to 14.4% for the largest and most complex non-sifis.

SwitzerlandThe swiss authorities have moved fastest and farthest among the major countries in imposing a new regulatory environment on its domestic banking system. The emphasis has been on imposing strict new guidelines on the two major banks, which combine to play an important role in domestic financial intermediation, but that also play an important role in international banking markets. These regulatory changes have occurred in three waves:

• The Swiss Federal Banking Commission (SFBC), in close cooperation with the swiss national bank (snb), adopted stricter capital measures in 2008Q4. This involved an increase in the local buffer to be applied to the basel ii minima and the introduction of an overall leverage ratio. although the requirement was established such that both measures were to be achieved gradually by the end of 2012, the rapid adjustment efforts of the two major banks in 2009-10 have been such that both criteria have been achieved more than two years ahead of schedule.

• A new liquidity regime for both big banks entered into force in mid-2010. This essentially requires the two large banks to meet the basel iii lCR ≥ 100 percent requirement (see page 21) four and a half years ahead of the global standard.

• A Commission of Experts was formed in the aftermath of the crisis, consisting of regulators, academics and Industry representatives. The Commission issued its final Report in october 2010,29 and the conclusions of this Report are now

in the process of being written into legislation. The Commission’s main focus was how to reform and expand the bank capital regime so as to make banks far more resilient. in the proposal, the main way of achieving this is to raise overall capital buffers on the two large banks even more substantially than was done in 2008Q4, through the introduction of a progressive component.30 This would leave the two largest banks required to observe a minimum capital ratio of 19 percent of risk-weighted assets by the end of 2018. The innovation of the swiss proposal, however, is that a significant portion of the new progressive component, as well as part of the normal buffer required over the basel iii minima, can be met through the issuance of contingent capital (or CoCos) – a form of convertible debt that, unlike traditional bank debt, has much better loss absorbing characteristics and which, thus, can legitimately be considered as a form of Tier 1 capital. by appealing to bond investors, however, such instruments might allow the large swiss banks to diversify and thus cheapen their sources of funding. of course, there may be instruments other than CoCos that can be used to meet the new capital requirements. This could include write-down debt instruments without conversion features.

To assess the whole economy impact of the additional requirements on the large firms, it is necessary to weigh together the sizeable new capital burdens on the larger firms with the more modest (basel iii) increases on the smaller banks to generate a system-wide average (Table 1.5).31

Table 1.5: New Swiss Capital Requirements

Large banks Small banks Aggregate

Capital requirement (% of RWAs)

Share of CoCos (permissible)

Share of common equity

Capital requirement (% of RWAs)

Capital requirement (common equity % of RWAs)

CoCos as % of RWAs (permissible)

Common equity 4.5% 0% 100% 4.5% 4.5% 0%

Buffer 8.5% 35% 65% 2.5% 4.1% 1.6%

Progressive component

6% 100% 0% 0% 0% 3.2%

Total 19% 7% 8.6% 4.8%

13.4%sources: swiss expert Commission (2010) and iif staff estimates.

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united States

Capital Dodd-frank/basel iii requirements: • higher core ratios (common equity, Tier 1 and total) – including increased regulatory minima and buffers. • lower Tier 2 ratio – reduced by 0.05% of Rwas from 2012. • Redefinition of capital – estimated at $ 38 billion a year over the period 2014-18. • higher risk weightings – on trading and banking book exposures. • sifi surcharge – estimated at 1.5% of Rwas.

liquidity ratios mortgage lending projected to grow by 2 percentage points less than nominal GDp from 2012 onward. lending to companies projected to grow by 5 percentage points less than nominal GDp over the period 2012-16 inclusive.

long-term bond issuance projected to grow by 5 percentage points more than nominal GDp from 2012 onward.

Charges and levies Dodd-frank measures: • interchange fee restriction - $5 billion a year from 2011. • Deposit insurance - $4 billion a year from 2011. • supervision and examination fees - $0.06 billion a year from 2011. • financial crisis responsibility fee - $3 billion a year from 2012. • seC fees - $5 billion a year from 2012.

wholesale funding costs Dodd-frank implications: • a 8bps increase in long-term wholesale borrowing costs from 2014 due to the implementation of the volcker Rule. • a 11bps increase in long-term wholesale borrowing costs from 2012 due to the implementation of the derivatives rule. • a 100bps increase in long-term wholesale borrowing costs from 2011 intended to capture the effect of reduced demand by debt investors.

miscellaneous an increase in non-interest costs related to the implementation of Dodd-frank regulations – $3 billion a year from 2010.

increased share of retained profits (needed to meet part of the new capital requirements) implemented from 2011 onward.

appendix 1.1: speCifiC assumpTions on ReGulaToRy RefoRm used in The iif models

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euro area

Capital basel iii measures: • higher core ratios (common equity, Tier 1 and total) – including increased regulatory minima and buffers. • lower Tier 2 ratio – reduced by 0.01% of Rwas from 2012. • Redefinition of capital – estimated at €47 billion a year over the period 2014-18.• higher risk weightings – on trading and banking book exposures and external (high-grade) assets. • sifi surcharge – estimated at 1.08% of Rwas. Repayment of public sector funding – assumed to be performed in seven equal installments between 2011-17.

liquidity ratios Cash and government bond holdings projected to grow by 5 percentage points more than nominal GDp from 2012 onward.

lending to financial companies projected to grow by 2 percentage points less than nominal GDp from 2012 onward.

lending to companies and companies assets held on the trading book projected to grow by 5 percentage points less than nominal GDp over the period 2012-18.

lending to households projected to grow by 4 percentage points less than nominal GDp over the period 2012-17.

external risky assets holding projected to grow by 5 percentage points less than nominal GDp from 2012 onward.

other assets holding projected to grow by 2 percentage points less than nominal GDp from 2012 onward.

Retail deposits projected to grow by 1 percentage point more than nominal GDp from 2012 onward. spreads on retail deposits also increased from 2012 onward to attract higher deposits growth.

Domestic financial liabilities projected to grow by 10 percentage points less than nominal GDp from 2012 onward.

short-term wholesale market borrowing set at €500 billion from 2013 onward.

external liabilities projected to grow by 2 percentage points less than nominal GDp from 2012 onward. other liabilities projected to grow by 12 percentage points less than nominal GDp from 2012 onward.

bank levies an increase in tax payments by €5 billion a year starting in 2012 – to include new bank taxes in Germany, france, and austria.

wholesale funding costs long-term wholesale borrowing costs assumed to increase by 25 bps a year over the period 2011-15 to capture the effect of increased risk.

miscellaneous Compensation costs assumed to grow by 3 percentage less than nominal GDp from 2012 onward.


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Japan

Capital basel iii measures: • higher core ratios (common equity, Tier 1 and total) – including increased regulatory minima and buffers. • Redefinition of capital – estimated at ¥2.4 trillion a year over the period 2014-18. • higher risk weightings – on trading book exposures (phased in between 2012-14), on lending to financial institutions (from 2014 on) and external (high-grade) assets (from 2014 on). • sifi surcharge – estimated at 1.7% of Rwas.

liquidity ratios lending to companies projected to increase by less than nominal GDp (by an average of ¥9.4 trillion a year) from 2012 onward.

lending to households projected to increase by less than nominal GDp (by an average of ¥4 trillion a year) between 2012 and 2014.

Retail deposits projected to increase by less than nominal GDp (by ¥5 trillion a year) from 2012 onward.

short-term wholesale market borrowing set to fall gradually from 2011 onward, while long-term wholesale market borrowing assumed to increase at an accelerated pace over the same period.

wholesale funding costs long-term wholesale borrowing costs assumed to increase by 100bps from 2011 on to capture the effect of increased risk.

miscellaneous non-interest costs assumed to grow by 3 percentage points less than nominal GDp from 2012 onward.

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united Kingdom

Capital basel iii measures: • higher core ratios (common equity, Tier 1 and total) – including increased regulatory minima and buffers. • lower Tier 2 ratio – reduced by 0.2% of Rwas from 2011. • Redefinition of capital – estimated at £14.4 billion a year over the period 2014-18. • higher risk weightings – on trading book exposures and lending to the corporate (financial and non-financial) sector. • sifi surcharge – estimated at 1.8% of Rwas.

Repayment of public sector funding (£65 billion) – assumed to be conducted between 2013-15.

liquidity ratios Cash and Gilt holdings projected to grow by 5 percentage points more than nominal GDp 2012-16, inclusive.

exposures to domestic financial companies and non-financial corporates assumed to grow 3-5 percentage points less than nominal GDp until 2016 inclusive.

mortgage lending projected to grow by 3 percentage points less than nominal GDp over the period 2012-16, inclusive.

external (risky) assets projected to grow by 3 percentage points less than nominal GDp from 2012 onward.

borrowing from financial companies assumed to grow by 5 percentage points less than nominal GDp from 2011 onward.

long-term bond issuance projected to grow by 5 percentage points more than nominal GDp 2012-16, inclusive. short-term wholesale borrowing assumed to grow by 5 percentage points less than nominal GDp starting in 2011.

bank levy Tax on bank liabilities (2011 onward). estimated to raise between £1- £2 billion a year.

wholesale funding costs long-term wholesale borrowing costs assumed to increase by 100bps from 2011 on to capture the effect of increased risk.

vickers’ Reforms – ring-fencing and separated capitalization assumed to increase funding costs by 25bps from 2012.

miscellaneous non-interest costs assumed to grow by 3 percentage points less than nominal GDp from 2012 onward.


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Switzerland

Capital sfbC/basel iii measures: • higher core ratios (common equity, Tier 1 and total) – including increased regulatory minima and buffers. • Redefinition of capital – estimated at a total of Chf29 billion over the period 2014-18. • higher-risk weightings – on trading book exposures, on lending to financial institutions and external (high-grade) assets. • sifi surcharge – estimated at 1.8% of Rwas. • progressive component (of the national buffer) – raised by the largest banks from 2013 on (in CoCos).

liquidity ratios Government bonds holding projected to increase more than nominal GDp between 2012-15, inclusive.

external (high-grade) assets projected to grow by 3 percentage points less than nominal GDp from 2012 onward.

Retail deposits projected to increase by 1 percentage point more than nominal GDp from 2011 onward.

long-term bond issuance projected to increase by more than nominal GDp from 2011 onward.

funding costs long-term wholesale borrowing costs assumed to increase by 100bps from 2011 on to capture the effect of increased risk.

Contingent capital coupon projected to increase on account of issuance pressures.

miscellaneous Compensation costs assumed to grow by 3 percentage points less than nominal GDp from 2012 onward.


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32 The banking and broader financial industry has completed a series of wrenching adjustments since the onset of the financial crisis in the middle of 2007. many financial institutions have been either liquidated or merged; whole sectors of the financial industry have disappeared or been reformed; market mechanisms and transparency have improved; and, perhaps most importantly, industry behavior has been radically changed by the experiences of 2007-08.32

among the key changes already registered have been significant efforts by banks to boost capital and liquidity ratios. These adjustments have generally occurred well ahead – not only of the passage of formal reforms programs designed to achieve such outcomes, such as basel iii – but also ahead of any timetable for the actual implementation as set out in various reform agendas (see, for example, Table 1.2, page 19).

in our estimates, the combined aggregate core Tier 1 capital ratio for the five jurisdictions covered in this study has risen from 7.3 percent of risk-weighted assets (Rwas) at the end of 2007, to 9.3 percent of Rwas at the end of 2010 (see panel f, Chart 2.8, page 37). The combined liquidity ratio of banks in the five jurisdictions – defined as the stock of cash and government debt holdings relative to on balance sheet assets – has risen from 6.7 percent of total assets at the end of 2007, to 9.7 percent of total assets at the end of 2010, or from 14.3 percent of Rwas at the end of 2001, to 20.7 percent of Rwas at the end of 2010.

four sets of factors have interacted to lift key capital and liquidity ratios well ahead of the formal full introduction of globally coordinated post-crisis regulations:

• first, and probably most important, the crisis has made bank managers themselves far more conservative in their behavior and, thus, in the desired structure of their balance sheets.

• second, financial markets have added to the squeeze. before the crisis, equity investors generally saw high

capital ratios as an inefficient use of capital and pressured bank managers to either return capital to shareholders or increase risk assets; now, bank managers are generally rewarded by equity markets for maintaining higher core equity ratios.

• Third, supervisors have begun to enforce higher capital and liquidity ratios well ahead of the implementation of globally agreed-on norms. in some cases, this reflects the introduction of new, local-specific norms (e.g., in switzerland, where banks were required to raise capital and liquidity ratios in 2008); in other cases, it reflects the implementation of stress tests, which were designed to bolster general economic confidence by lifting fears about the resilience of the banking system. in the united states, the stress test of early 2009 (otherwise known as the supervisory Capital assessment program, or sCap) showed that under an adverse scenario, 10 of the 19 sCap banks would need to raise a total of $75 billion in capital in order to have the capital buffers that were targeted under the sCap.33 in a speech in march 2001, federal Reserve Governor Daniel k. Tarullo noted that by “november 2009, the 10 banks that required additional capital had increased their Tier 1 common equity by more than $77 billion, primarily by issuing new common equity, converting existing preferred equity to common equity, and selling businesses or portfolios of assets”.34 in europe, the publication of the results of the 2011 european banking authority (eba) stress test exercise revealed that several banks had made substantial efforts to improve their capital position in the first half of the year, largely in anticipation of the exercise itself.35

• finally, many banks are adjusting as rapidly as possible to new international norms for both capital and liquidity well ahead of their formal timetabled introduction. indeed, we consider such behavior explicitly in our empirical work by developing an accelerated adjustment scenario (see section 5, pages 49-75).

seCTion 2: pRoGRess To daTe and implied disTanCe To adjusT

32 see iif (2008).33 Tier 1 capital in excess of 6% of Rwas and core Tier 1 capital in excess of 4% of Rwas at the end of the two-year horizon. see Tarullo (march 2010).34 in addition to the sCap, us banks are subject to a Comprehensive Capital analysis and Review (CCaR), the first of which (carried out in early 2011)

resulted in dividend payments restrictions for some banks.35 see eba (2011).

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in our view, this progress to date raises two important issues relating to the debate over the economic impact of tougher regulatory measures. first, it provides something of a guide as to how, for example, the need to achieve higher capital ratios is liable to affect bank behavior and the broader economy. second, the extent of adjustment to date raises the question of how much more adjustment still lies ahead. The rest of this section looks at each of these issues in turn.

2.1 the CoSt of aDJuStment to Datewe believe that the sluggish and generally disappointing recovery in the mature economies from the depths of the 2008-09 crisis is supportive of the view developed in our Interim Report that tougher regulatory measures, enacted early in what was inevitably shaping up to be a fragile business cycle, would exert a significant restraining

effect on the economic expansion. Developments to date certainly don’t prove that our analysis was correct, but in tracking developments we are more, not less, confident about our core conclusions.

The funding backdrop for banks has been relatively unfavorable in the past year (see section 4). banks raised substantial amounts of equity in 2008-09, although much of this came through emergency purchases by governments. in the past year and a half, equity issuance has been quite low. in the year through 2011Q1, banks raised a total of just $47 billion, virtually all of which was raised by banks in europe (Charts 2.1 and 2.2). in this period, banks evidently preferred to improve their capital ratios through a combination of risk-weighted asset reductions and the retention of profits.36 bank managers have also focused on repaying government equity injections.

with the growth in the numerator of the capital ratio limited, the main mechanism through which higher capital ratios have been achieved is through reductions in the denominator. across all the major economies, there was an outright reduction in bank assets in 2009, followed by a relatively modest – and cyclically atypically weak – rebound in credit (in 2010-11; Chart 2.3). not all bank asset reductions represented a reduction in credit to the non-financial private sector. some reflected a reduction in lending between financial institutions. That said, however, weakness in overall bank asset growth has translated into generally disappointing credit growth (Chart 2.5), particularly to the non-financial corporate sector (Chart 2.4). while the evidence is somewhat anecdotal, there are signs that small and medium-sized businesses and other lower-rated credits have found it particularly hard to borrow. The asset reduction was especially sharp for switzerland, where the two large banks reduced external assets very significantly in 2008-09.

The weakness in credit availability to the non-financial private sector and the pressure to accelerate de-leveraging within the financial sector appear to have contributed to the disappointing economic performance in the mature economies over the past 18 months. Three examples stand out:

• The us expansion has been a disappointment to both policy makers and market participants alike. one benchmark of this disappointment can be obtained by tracking the forecasts of the federal Reserve for the us economy in 2011 (Chart 2.6). early in 2010, the staff of the federal Reserve was projecting us real GDp growth to be about 4 percent for 2011 (Q4/Q4 basis), which would not be an unreasonable assumption for the second to third

36 in some countries, however, the increase in the tax burden for banks may have reduced the scope for profit retention.

0

50

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07Q3 08Q4 10Q1 11Q2

Net New Bank Capital Issued 2007Q3-2011Q2 (total)$ billion

Chart 2.1

source: bloomberg.

0

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150

200

250

07Q3 08Q4 10Q1 11Q2

Americas

Europe

Asia

Net New Bank Capital Issued 2007Q3-2011Q2 (by region)$ billion

Chart 2.2

source: bloomberg.

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37 These concerns were reflected in the iif Interim Report (2010), pages 60-66.

year of a us recovery – especially one benefiting from such extreme monetary support from the fed itself. at the time, iif staff felt that growth in 2011 would be far more modest, however, in part because it was concerned about the headwinds resulting from the extensive array of regulatory reforms, which we felt would hold back private sector demand at a time when public sector demand would be fading due to fiscal pressures.37 as 2010 progressed, and the prospects for 2011 began to

worsen, the fed surprised most (including iif staff) by embarking on another round of monetary stimulus (a second round of large-scale asset prices, commonly dubbed Qe2). for a while, that policy stimulus appeared to be working well and the economic data strengthened materially; in response, the iif staff revised up its forecasts to incorporate these developments. since then, however, a number of factors – some temporary, but some more fundamental – have taken the steam out of growth

-15

-10

-5

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00 01 02 03 04 05 06 07 08 09 10

UnitedKingdom

UnitedStates

Japan

Euro Area

Switzerland

Banking Sector Assets%y/y

Chart 2.3

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1993 1996 1999 2002 2005 2008 2011

Bank Lending to Private Sector% ch over a year ago (both scales)

United Kingdom United States

Euro Area

Chart 2.5

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Credit to Non-Financial Corporate Sector%y/y

Chart 2.4

source: national sources and iif calculations.

source: Central banks statistics and iif calculations.

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in 2011, leaving most key policymakers somewhat puzzled as to why growth is persistently weak. in our view, the headwinds of regulation dampening an already fragile financial sector are an important contributory factor to this growth disappointment.

• The past year has also seen surprising persistence and virulence in the sovereign debt crisis within the euro area. This turmoil has continued despite official support measures for troubled, indebted governments that are unprecedented in scale and scope. The result has been an extreme divergence in financial conditions within the euro area (Chart 2.7). while there are many factors behind the euro area crisis, we believe that the region’s difficulties have not been helped by measures that have promoted and accelerated de-leveraging within the region’s financial system. in our Interim Report, we warned that the euro area could be particularly vulnerable in the process of regulatory reform, in part because the region’s economy is relatively heavily dependent on banks for debt financing, and because the new requirements would necessitate europe’s banks to make a significant adjustment over a relatively short time horizon (2011-15), especially in their cross-border lending within the region. in addition, all of this would be occurring against the backdrop of sustained efforts to reduce budget deficits – efforts that could be undermined by private sector financial weakness.38 we believe that these factors have made a significant contribution to the turmoil of the past year. indeed, we believe that the most recent turmoil within the euro area reflects a worrying rush to de-lever among european banks that risks becoming a seriously destructive vicious spiral.

• in the united kingdom, expectations that credit growth would strengthen and credit spreads would decline have been repeatedly disappointed over recent months. This appears to reflect the fact that uk banks continue to be affected by a climate of risk-aversion among banks’ investors (see haldane 2011), despite the improvements uk banks have made towards restructuring their balance sheets and improving resilience, while at the same time committing to support the economy as part of the so-called project merlin.39 Consequently, credit conditions have remained tighter than before the crisis, contributing to the disappointingly slow pace of economic recovery of the recent quarters (see bank of england 2011).

switzerland is sometimes cited as an example of how drastic banking reform can be achieved with relatively little macroeconomic damage.40 The swiss economy has indeed performed very well through the de-leveraging of the two major banks. most of that de-leveraging took the form of a shedding of external assets, however, and domestic credit growth within switzerland has been quite robust by mature market standards (see Chart 2.4). The macroeconomic impact of this phase of swiss bank de-leveraging was thus felt almost entirely abroad. in 2007-09, this will have been primarily in the united states. more recently, the spillover may also have spread to the periphery of the euro area.

38 see the iif Interim Report (2010), pages 88-93.39 in february 2011, an agreement was signed between the uk government and the four biggest uk banks. The so-called project merlin included a

commitment by the banks to increase the amount of lending in 2011, particularly to small businesses.40 see Jordan (2011).

U.S. Real GDP Growth Forecasts for 2011 Q4/Q4 (as published in IIF monthly GEM)

1.5

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IIF staff QE2 launched

Chart 2.6

source: federal Reserve and iif staff estimates.

0

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Germany, GIIPS: 2Y Government Bond Yieldspercent

Germany

Greece, Ireland, Italy, Portugal, Spain

Chart 2.7

source: bloomberg.

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41 in the Cee (Central and eastern european) region, the importance of the banking sector is particularly related to the almost total absence of debt markets for non-financial corporates.

42 it has become popular to refer to these alternative debt intermediation channels as “shadow banking”. in our view, this term is best reserved for institutions and sectors that both intermediate debt from lender to borrower and, in so doing, transform short-term (and supposedly liquid) liabilities to longer-term (and less liquid) assets.

43 see the iif Interim Report (2010), pages 60-66.44 see for instance the discussion in fsoC (2011).

2.2 the extent of aDJuStment StiLL aheaDin looking ahead, Table 2.1 gives a broad outline of some of the factors liable to shape the impact of regulatory reform (this should be looked at in the context of Chart 1.1, page 17). The first three columns show where, in aggregate, banking systems are placed when it comes to meeting key basel iii parameters. The last two columns illustrate the importance of the banking system to the economy, expressed both in terms of the system’s scale relative to GDp and in terms of the importance of banks in the overall process of debt intermediation in the economy. The following should be noted:

• Core capital ratios vary quite significantly across jurisdictions. The us banking system has adjusted quite significantly over recent years and is relatively well capitalized. by contrast, the Japanese system, which was least affected by the turmoil in 2008-09, is relatively poorly capitalized.

• banking systems are generally operating today with liquidity ratios below where they need to be on the new standards, although it is hard to be confident about our calculations. it should be noted that they are based on aggregate data. The ratios reported seems quite consistent with the data provided in recent official sector quantitative impact studies, however.

• banks are relatively more important in europe in two senses: they play a relatively large role in the

debt intermediation process and they are relatively large compared to the economy.41

• it is important to give some consideration to the outlook for non-bank debt intermediation sectors when considering the impact of regulatory reform.42 where banks do not dominate the intermediation landscape (as in the united states), the ability of the non-bank sector to offset the restraint of reform on banks is an important consideration. in the current reform environment, it is not clear that such a “spare tire” sector can flourish.43 where alternative debt intermediation systems are limited in scale, it is important to consider whether tougher regulation on banks could lead to a rapid disintermediation of debt flows, which could undermine the supposed stability gains resulting from tougher bank regulation.44

There is no single obvious metric relating to progress made and distance still to adjust in the global banking environment, but common (risk asset-weighted) equity ratios provide one benchmark. in the past three years, core Tier 1 capital ratios have risen by 2 percentage points of risk-weighted assets (Chart 2.8, panel f). These ratios have been dragged down by bank losses in 2007-08, but boosted by equity issuance and, especially, through reductions in Rwas. in coming years, the redefinition of capital will further reduce these ratios and form the base from which banking systems will have to climb to meet the exacting standards likely to emerge should all the measures now under serious consideration become effective.

table 2.1: factors affecting the impact of regulatory reform end – 2010

Core Tier 1 capital ratio

Core Tier 1 capital ratio after redefinition

Liquidity Coverage Ratio

Net Stable Funding Ratio

Bank assets as % of GDP

Banks’ share of credit intermediation

United States 11.8% 9.5% 86% 80% 82.5% 24.6%

Euro Area 9.4% 7.6% 69% 73% 353.5% 70.0%

Japan 5.2% 2.1% 108% 78% 168.6% 54.1%

United Kingdom 8.6% 6.5% 81% 90% 539.3% 73.5%

Switzerland 10.6% 7.7% 87% 67% 497.0% 85%

Total 9.3% 7.2% 79% 77% 226% 55.6%

sources: national sources and iif staff estimates.

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sources: iif staff estimates.

Chart 2.8 Banks’ Capital Raising Challenge

*new Definition ** dollar denominated Rwas-weighted

8.3%

11.8%

9.5%

14.2%

11.3%

0%

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16%

2007 2010 2010* 2015e 2020e

United States core Tier 1 capital as %RWAs

Panel A

4.5% 5.2%

2.1%

9.1% 9.1%

0%

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10%

2007 2010 2010* 2015e 2020e

Japan core Tier 1 capital as %RWAs

Panel C

6.0%

10.6%

7.7%

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2007 2010 2010* 2015e 2020e

Switzerland core Tier 1 capital as %RWAs

Panel E

8.1%

9.4%

7.6%

13.1% 13.1%

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6%

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14%

2007 2010 2010* 2015e 2020e

Euro Area core Tier 1 capital as %RWAs

Panel B

5.9%

8.6%

6.5%

11.1% 11.1%

0%

2%

4%

6%

8%

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12%

2007 2010 2010* 2015e 2020e

United Kingdom core Tier 1 capital as %RWAs

Panel D

7.3%

9.3%

7.2%

12.5% 12.0%

0%

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4%

6%

8%

10%

12%

14%

2007 2010 2010* 2015e 2020e

Total (5 jurisdictions)** core Tier 1 capital as %RWAs

Panel F

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seCTion 3: a fRamewoRk To assess The CosTs assoCiaTed wiTh ChanGes in The finanCial ReGulaToRy fRamewoRk

in assessing how all the regulatory changes facing the banking sector might affect the global economy, two steps are necessary: first, develop a framework of the banking sector to assess how that sector itself will be affected by the changes in regulation; second, link the output of that framework to a model of the global economy.

any such approach inevitably involves a certain degree of discretion, in the choice of the model and in the definition of the assumptions underpinning the model. Consequently, the results generated are going to be affected by such choices, which are based on subjective judgment and therefore open to discussion. our effort has been directed toward developing a framework sufficiently transparent to allow other analysts to understand how we have reached our assessment and engage them in a constructive debate.

in our analytical work, we assess that tougher financial regulations impart a cost to economic activity both by raising the cost of credit to the private sector, and by reducing credit availability. in turn, this overall tightening in private sector credit conditions is driven by three factors (Chart 3.1):

• Regulatory reform changes the pattern and cost of bank funding, and this higher cost of funding

is passed on to borrowers in the form of higher lending rates.

• Regulatory reform changes the mix of bank assets, encouraging or requiring banks to hold more lower-yielding claims on public sector entities and thus biasing banks against lending to private sector borrowers, especially at the more risky end of the spectrum.

• Regulatory reform may even change banks’ business models, persuading them to exit certain business lines.

3.1 reguLatory reform anD the impaCt on BanK LenDing rateSbanks use the price mechanism as their primary tool for intermediating credit to the private sector. They fund themselves at particular prices (interest rates) on one side of their balance sheet and, on the other side, lend to the private sector at a spread set by a mixture of their own objectives and broader economic conditions.

The starting point for an analysis of the lending rate implication of banks’ funding costs is the definition of post-tax bank profits (π):

π = (1-T) * (rlala + rRaRa – rDD - rbb + k) (1)

Regulatory Reform

Pattern andcost of bank

funding

Bank assetallocation

Bankbusinessmodel

Terms andavailability of

credit (bank andnon-bank) toprivate sector

Impact onEconomy

Chart 3.1 Stylized Framework of the Economic Impact of Regulatory Reform

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45 see iif (2011b).46 These measures are additional to the basel iii requirement that Tier 2 capital instruments must have conversion or write-down features, in many ways

equivalent to bail-in.

where T is the average tax rate charged on bank earnings, rla is the average rate banks earn on their liquid asset holdings (la), rRa is the average rate banks earn on their risky assets (Ra), rD is the average rate paid on deposits (D), rb is the average rate paid on bond debt (b) and k is banks’ net non-interest earnings, a catch-all variable that would include labor costs and other income—such as fee income and trading revenue—as well as important other variables, such as credit losses.

with some rearrangement, this definition can be turned into a simple model of the banking sector that allows us to assess the impact of various proposals for regulatory reform.

first, divide through by bank equity (e), and treat π/e (or Roe) as a target variable for the bank. note that this target is set not by the banks themselves, but by investors in bank equity – a market-based target that bank managers are then expected to achieve. next, assume that banks set the lending rate on risky assets so as to achieve that rate of return target:

rRa = [Roe/(1-T)] * (e/Ra) + rD (D/Ra) (2)+ rb (b/Ra) – rla (la/Ra) – (k/Ra)

This equation tells us that banks’ desired lending rate (rRa) will be in part a weighted average of the relevant funding rates, with the weights on those rates reflecting the relative shares of those liabilities on the funding of those risk assets on banks’ balance sheets. The lending rate will also be affected by the rate that banks can earn on their liquid assets, as well as the banks’ abilities to generate net non-interest income.

equation (2) is quite helpful as a way of capturing the many channels through which key measures of regulatory reform can affect banks’ lending rates and, in so doing, affect the path of economic activity:

• higher capital requirements. it might reasonably be assumed that Roe > rb > rD. in other words, the returns that banks are expected to pay equity holders exceed those paid to bond holders which, in turn, exceed those paid to depositors. This primarily reflects the fact that, in the majority of countries, depositors are senior to bond holders, who are in turn senior to equity holders in the banks’ funding structure. in this case, a rise in required equity holdings, that is, a rise in (e/Ra) will lead to a rise in rRa. essentially, by requiring more equity, shareholders are diluted. so banks will have to increase post-tax profits by charging a higher lending rate in order to offer shareholders the same rate of return. note that the precise increase in

rRa will be determined by the extent to which the targeted Roe exceeds the deposit and bond funding rates. a very important issue for discussion—one that is reviewed extensively in section 4—is how this Roe target might respond to the requirement of a higher equity ratio (e/Ra). indeed, different views on this issue go a long way toward explaining different assessments of the macroeconomic impact of regulatory reform.

• higher liquidity requirements. Tougher liquidity requirements will affect both sides of the banking systems’ balance sheet. banks will be required both to hold more liquid assets, and to term out their debt structure by issuing more long-term debt. To assess the impact of higher liquid asset holdings, it is necessary to make some assumptions on how these additional assets will be funded. in our framework, we assume that necessary higher holdings of liquid assets are funded by borrowing from the bond market (wholesale funding). in such a case, the impact on the lending rate, rRa, is straightforward as the interest rate differential between the marginal cost of new funding, and its marginal return: (rD – rla). note that this differential could well widen as amounts involved increase, mainly because a higher supply of bank bonds is liable to depress their price and thus raise their yield. once again, this factor is considered in some detail in section 4.

• new bank resolution regimes. bank resolution regimes that make the claims of bondholders more likely for forced conversion into equity are liable to raise spreads on bank bonds and thus rb. Depending on the relevance of this funding source for banks, this would raise the lending rate on risky assets, rRa. There is particular uncertainty over the conditions governing senior debt in such new “bail-in” plans. it is important to point out that the banking industry itself has proposed approaches to resolution that also include a role for senior debt as well as subordinated debt,45 while the fsb has recently advanced a proposal for “bail-in within resolution” (see fsb 2011).46 it should be noted that the demand for longer-term bank bonds will probably be reduced by other (non-basel iii) regulatory measures, such as restrictions on such bond holdings by money market funds and insurance companies. This will further raise rb.

• higher taxes on banks. a number of regulatory proposals take the form of an increase of effective tax rates on banks. higher average tax rates would reduce

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40

47 in a number of countries, reforms of bank executives pay have been introduced. They include measures such as deferral of a proportion of variable pay and bonuses, or payment in the form of shares, as well as greater pay transparency. in our reform scenarios, we assume that such measures combine to hold down the increase in banks’ non-interest costs to 3 percentage points less than nominal GDp throughout the projection horizon. This compares to our baseline scenario, where non-interest costs are projected to rise in line with nominal GDp.

the post-tax return on equity and thus boost banks’ required lending rates. note that this effect could be compounded by higher bank equity requirements, as banks are required to fund more of their balance sheet through what higher taxes effectively make a more expensive funding instrument.

• Restrictions on banks’ non-interest business. while these do not form part of the basel iii related measures, other reform programs – most notably the Dodd-frank legislation in the united states and the deposit guarantee schemes, resolution funds, taxes and levies across the european union—impose some restrictions on banks’ non-interest earning capabilities. such a reduction to the variable, k, in equation (2) would feed directly into higher lending rates, and would thus restrain economic activity through that channel. This would be in addition to any harm done through any resulting reduction in the cost and availability of credit from non-bank sources. note that the variable, k, is also the channel through which lower labor compensation costs could dampen the lending rate impact of regulatory reform, since (all other things equal), lower labor costs would raise k and thus lower rRa (see section 3.3).47 it is also the variable through which the higher costs of meeting enhanced regulatory reform requirements would be expressed. These include technology costs for development of enhanced supervisory reporting and public disclosure, augmented risk management and collateral requirements, new infrastructure and systems changes as business models are adapted.

3.2 reguLatory reform anD Quantity aDJuStmentalthough such a lending rate adjustment approach seems a reasonable first approximation to how banks will react to the requirements resulting from tougher regulation, it is not the only way in which they are liable to adjust. banks might also choose to adjust quantities (i.e., to cut credit availability) rather than relying solely on higher pricing (lending rates). This quantity adjustment might occur for several reasons:

• most significant, banks may find that the amounts of capital needed to meet new requirements may exceed amounts that capital markets are willing to supply at an acceptable near-term cost. in such a case, banks would cut risk assets to satisfy higher required ratios.

• alternatively, banks might be able to raise substantial capital amounts – albeit at a sharply higher marginal cost – but be constrained from passing on the costs associated with such capital accumulation to borrowers in the form of higher lending rates. This may simply be because banks’ offers to lend at higher rates are turned down by non-bank borrowers unwilling to pay these higher rates. There may also be outright credit rationing for some small and less creditworthy borrowers (both businesses and households), where simply charging higher interest rate spreads might raise concerns about adverse selection.

• it is also possible that banks would respond to a requirement to hold more liquid assets (la) simply by reducing loans (Ra). in such a case, the net impact of tougher liquidity requirements could turn out to be quite dramatic.

• banks are liable to change business models and stop doing certain activities altogether. They are especially likely to exit from historically lower-margin businesses such as backup lines of credit, including for trade finance, if they cannot be re-priced to the necessary extent.

one way of illustrating the combination of price and quantity effects liable to result from the process of banking regulatory reform is to model the combination of regulatory changes as representing a leftward shift in the aggregate credit supply curve from the banking sector (Chart 3.2): for any given lending rate, banks would be willing to supply less credit. assuming a stable, downward sloping demand curve for credit, then a shift in credit supply (from s1 s1 to s2 s2) would lead to higher prices (i.e., lending rates) and lower quantities (i.e., reduced credit).

The empirical challenge is how to determine the relative contribution of price and quantity effects liable to play out in the real world. Chart 3.3 shows a stylized framework, where we plot the combination of quantity restraint versus price (lending rate) adjustment that delivers a given degree of banking sector reaction to a toughening in regulatory conditions. To generate specific macro-estimates, we need to make a judgment on how to allocate lending rate versus quantity adjustments – that is, where we think the system will end up on this curve. our bias, as noted above, is to assume that banks use the price mechanism as their primary tool for intermediating credit to the private sector. in our work, therefore, we have effectively

41

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48 see morgan stanley and oliver wyman (2011).49 in our models, this applies to the united kingdom and Japan. for switzerland and the euro area, where compensation costs are explicitly identified,

we assume that compensation costs grow by 3 percentage points less than nominal GDp over the scenario horizon. see appendix 1.1.

assumed that banks (in aggregate) choose to position themselves at somewhere such as point a in Chart 3.3. we could, alternatively, have chosen an alternative point, such as b, which would imply less lending rate adjustment, but more quantity restraint.

it should be emphasized that an approach that stresses lending rate adjustment is not necessarily adding to the economic costs associated with regulatory reform. indeed, quantity adjustment through credit rationing is generally a more painful outcome for borrowers and, thus, negative for economic activity. moreover, higher lending rates have the near-term benefit of making banks more profitable. This aids in the acquisition of capital through retained earnings, making it easier to achieve desired capital ratios. in our framework, this helps lower the cost of capital over time, as banks can better meet the demands of equity investors for an adequate return.

3.3 reguLatory reform anD CompenSation aDJuStmentone way in which banks can adjust to some of the higher costs associated with regulatory reform is to restrain costs associated with labor compensation. This process is indeed underway. an industry study, undertaken by oliver wyman,48 shows compensation to revenue ratios of major investment banks falling from an average of 45 percent in 2004-06 to 33 percent in 2009-10 (see Chart 3.4 next page). some of this reduction reflects

explicit limits on compensation imposed by regulators. in a number of countries, reforms of bank executives’ pay have been introduced. They include measures such as deferral of a proportion of variable pay and bonuses, or payment in the form of shares, as well as greater pay transparency. but most of this restraint reflects an easing in labor market pressures.

in our reform scenarios, we assume that the combination of policies to restrain compensation and labor market conditions combine to dampen compensation growth in the years ahead, especially in the regulatory change scenarios. These measures combine to hold down the increase in banks’ non-interest costs to 3 percentage points less than nominal GDp throughout the projection horizon. Given that direct labor compensation amounts to about two-thirds of banks’ non-interest costs, this would translate into labor compensation costs that rise by about 5 percentage points less than nominal GDp throughout the projection horizon.49 This compares to our baseline scenario, in which non-interest costs are projected to rise in line with nominal GDp. There are, of course, limits to how much financial institutions can restrain labor costs. people are the basic resource of a bank and, as many state-owned banks are now discovering, labor cost restraint can make it difficult to attract and retain talent.

Compensation restraint thus helps dampen lending rate increases associated with tougher regulatory requirements but, quantitatively, cannot realistically be large enough to absorb much of the shock.

Credit

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Chart 3.2 Reform Amounts to a Leftward Shift in Banks’ Credit Supply Curve

Chart 3.3 Alternatives to Achieve a Given Level of Adjustment to Regulatory Change

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Chart 3.4 Evolution of Compensation*

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source: morgan stanley and oliver wyman (2011).

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seCTion 4: The key Role played by fundinG CosTs50

50 This topic is discussed in more detail in iif (2011a). see also elliott (2009), (2010a) and (2010b) and van hoose (2007).51 see haldane and Davies (2011) for a discussion and some evidence of short-termism in investors’ behavior.

The terms on which investors in bank equity are willing to supply new capital is one of the most important factors shaping the results of whether tougher regulatory policies requiring banks to maintain higher levels of capital will extract a meaningful economic cost. similarly, the terms on which bond investors will be willing to buy both traditional bonds as well as new instruments such as contingent convertible capital will further affect overall bank funding costs and, thus, the rates at which banks will be willing and able to provide credit to the rest of the economy. finally, the significant changes in banks’ asset holdings likely to be required by the liquidity proposals (at least in their current form) could significantly distort the cost and availability of credit, including credit in key areas such as finance for working capital and trade.

The range of plausible outcomes on these issues is quite wide. at one extreme, it is possible that existing and additional equity investors will take comfort from higher levels of capital resulting from the issuance of new capital, such that they will be happy to accept a lower rate of return. in such circumstances, the banking sector’s overall cost of funding and, thus, its lending rates would be minimally affected and there would be no significant economic cost associated with higher bank capital requirements. at the other extreme, it is possible that there would be virtually no appetite from investors to hold more bank equity. This could not only reflect the additional risks (relative to earlier periods) now embodied in bank equity (including regulatory risk), but it could also reflect the lack of appeal resulting from lower anticipated returns on (now more risky) equity, as well as severe restrictions on dividend payments, meaning that investors’ only returns would be reflected in capital gains.51 This is particularly the case when other, more profitable investment opportunities may be available: compared to the pre-crisis period, in some countries banks no longer offer the most attractive returns compared to other industrial sectors (see Chart 4.1, next page). in such circumstances, higher capital ratios would imply the need for a sharp reduction of risk assets held by banks. such a quantity-driven adjustment could be very costly,

especially if it were to occur relatively quickly. many of these same issues relate to the cost and availability of debt finance for banks (see iif, 2010).

in our view, the real world lies somewhere between the two extremes described above, and it is this middle ground approach that we have incorporated into our modeling work (see iif 2010). in this work, the cost of equity capital is a function of three basic factors. first, it is a function of the perceived riskiness of the banking sector as a whole. This is partly driven by investors’ perceptions of the underlying healthiness of the sector, especially the risks associated with the process of maturity transformation—banks’ core activity. it is also presumably inversely related to banks’ capital ratios. second, it is a function of near-term supply. in other words, investors’ demand curve for bank equity is downward sloping: the more banks are required to supply to meet regulatory requirements, the more they have to cut the price of that offering and, thus, the higher the return they have to offer to prospective investors. investors are also increasingly wary of regulatory uncertainty, making them vulnerable to further unexpected dilution. finally, in a highly uncertain world, the cost of capital is driven by banks’ ability to deliver on investors’ expectations: when banks deliver a rate of return in excess of the previous period’s target, then the rate required by investors in the next period is reduced, and vice versa.

The framework considered above is a key component of the iif cumulative impact models. To quantify the impact of specific regulatory changes, it is first necessary to map proposed changes into aggregate balance sheet effects. using the terminology introduced in section 3, in order to derive a specific path for the lending rate, rRa, however, it is necessary to take a view on how other key variables — specifically the rates of return on bank funding instruments (Roe, rb and rD) — will adjust as their quantities supplied increase to meet heightened regulatory requirements. in what follows, our main focus is on the rates of return that banks are required to pay investors (i.e., Roe and rb). This is mainly because these funding sources are considered to be managed liabilities.

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by contrast, deposits are taken as a given (and generally assumed to evolve in line with nominal GDp), and their pricing set at a fixed spread over the key short-term official interest rate. This, of course, could change, especially as banks become more aggressive about competing for deposits that are seen as a stable form of funding under the new liquidity rules. ironically, the increased competition could make such previously stable liabilities not only more expensive, but less stable, in future periods. another new aspect of behavior on the funding side that warrants some consideration is the introduction of contingent convertible capital (CoCo bonds), particularly “high trigger” ones. in principle, CoCos are simply a new form of convertible bond, with an embedded equity put option, triggered by a specific capital level. CoCo investors will presumably need to be compensated for the requirement to write such an option, in the form of a higher coupon payment (i.e., CoCos would raise rb). on the other hand, they might help reduce the required Roe (at least in the short term) by reducing required equity supply. The decision on what would be the optimum capital structure for banks operating in the new regimes allowing CoCos (e.g., switzerland) would thus presumably be shaped by the relative receptivity of the investor community to increased supply of these two classes of instrument.

4.1 the DeBate over the CoSt of BanK eQuityThe most contentious issue relates to how the rate of return on equity required by bank investors can

be expected to evolve as the new tougher regulatory regime takes hold. There are two conflicting stories told by analysts.

The first, which has been emphasized by a number of academics and policymakers, takes as its starting point the efficient market building blocks of the Capital asset pricing model or Capm (see king 2009) and the modigliani-miller theorem (m-m), which states that the cost of capital to a company is independent of its leverage ratio (modigliani and miller 1958). The essential point of m-m is that a larger equity base makes a bank less risky, both in the extreme sense of reducing the risk of failure and in the more mundane sense of making the period-to-period volatility of earnings (expressed in terms of the Roe) go down. as a result, investors would be happy to accept a lower rate of return on equity, and this effect will offset the effect of issuing what was initially a more expensive funding instrument. in terms of equation (2) in section 3, an increase in (e/Ra) due to regulatory reform would have no impact on rRa, since it would be fully offset by a decline in Roe. This view has been expressed by admati et al. (2010), kashyap et al. (2010 and 2011), miles (2010a and 2010b) and miles et al. (2011).

an alternative view emphasizes that rate of return expectations by investors are also affected by the actual supply of bank equity and expectations or fears of future supply requirements: in other words, quantities matter. according to this view, to the extent that regulatory reform would lead to a requirement of higher equity issuance, then this would either help offset the risk reduction benefits on the required Roe of a higher

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Chart 4.1

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52 see, for instance, bank of england (2011), page 4.53 in some aspects, these tools are based on the example of dynamic provisioning used by spanish banks. see saurina (2009a) and (2009b).

equity base, or possibly even put immediate upward pressure on that Roe until the new share issuance is comfortably held by investors (iif 2010). by contrast, the m-m approach effectively argues that additional supply can be absorbed by investors seamlessly: indeed, investors are content to accept a lower rate of return even as they become relatively more exposed to a particular sector.

To an extent, the argument over which model or approach is most appropriate is determined by the nature of capital market conditions that are seen to prevail. if the strict, neo-classical assumptions of the m-m theorem hold at all times, then the “bank equity is not expensive” argument would seem to be the most appropriate. on the other hand, it has been long accepted that the basic results of m-m are violated by most countries’ tax structures, which explicitly favor debt over equity. more fundamentally, if there are extreme uncertainties, information and markets are not complete, and investors are themselves credit constrained,52 then it seems quite likely that a significant additional net supply of a specific class of securities will require a shift in relative prices (possibly quite a decisive one in the near term) to attract investors to hold those securities on a willing basis. most industry practitioners question the validity and applicability of the m-m theorem. This may reflect a huge collective failing of insight and understanding by the industry, but it seems more likely to reflect the outcome of experience.

The relevance and appropriateness of each model would also seem to be, in part, a function of the time horizon. over time, as any equity supply pressure eases and higher levels of bank equity become both absorbed in investor portfolios and seen as a helpful, stabilizing influence leading to lower risk facing banks, then the required return would presumably decline in line with the basic m-m premise, although even long-run relevance can be questioned, given the exacting neo-classical complete market assumptions needed to make m-m results stand. but, in the short run, as ownership dilution concerns dominate, then heavy required (and/or feared) equity issuance could depress bank equity prices, thus raising the short-run cost of equity finance. it seems that recognition of this issue was a key factor behind the decision of the basel Committee on banking supervision to provide a significant phase-in period for the implementation of the higher capital standards in basel iii.

4.2 QuantitieS matterThe proposition that relative quantities matter in the pricing of financial assets is hardly a controversial one. in the world of equities, where the substitutability of different assets is obviously far from perfect, there is a fairly extensive literature pointing to significant, and sustained, declines in stock prices when there are surprise issues of equities; and jumps in stock prices when there are either surprise declines in equities issued or unexpected increases in demand (e.g., when the announcement is made of selected stocks to be added to key equity market indices, such as the s&p500). These effects have been well documented over both time and geography: see, for example, shleifer (1986), loderer et al. (1991), levin and wright (2006), huang et al. (2009), and petajisto (2009).

The notion that quantities matter in financial markets has also been pushed to the fore by the adoption by a number of central banks — most notably, the bank of england and the federal Reserve — of policies of quantitative easing. for these policies to be effective, an essential premise is that central bank purchases will affect relative prices. in articulating and defending this strategy in a number of recent speeches, federal Reserve vice Chair Janet yellen noted that “The underlying theory, in which asset prices are directly linked to the outstanding quantity of assets, dates back to the early 1950s. for example, in preferred-habitat models, short- and long-term assets are imperfect substitutes in investors' portfolios, and the effect of arbitrageurs is limited by their risk aversion or by market frictions such as capital constraints” (yellen, 2011).

finally, some of the supporters of a m-m view of the world are also among the proponents of capital-based macroprudential tools such as countercyclical capital buffers.53 These are predicated specifically on the assumption that more capital translates directly into less or more expensive lending. The disconnect is evident.

4.3 empiriCaL iSSueSin reality, therefore, the argument becomes something of an empirical issue. if the cost of issuing bank equity and debt is very expensive in the short run, then managers of banks will have an incentive to re-establish desired or mandated higher equity and liquidity ratios by reducing assets — a painful credit crunch for the economy. in turn, this credit crunch will worsen the performance of the economy, further undermining perceived bank asset quality, raising

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the cost of bank equity (i.e., depressing bank equity prices), and so on. once this vicious circle has worked its way through, higher capital and liquidity ratios are established, and the economy’s weakness begins to fade, then the cost of capital to banks would presumably fade and the longer-term m-m neutrality result would seem more relevant.

proponents of the view that higher bank equity requirements would not raise banks’ weighted average cost of capital, and, subsequently, bank lending rates, have tested this proposition by looking back at how bank lending rates have evolved alongside movements in bank capital ratios. Their results generally show a lack of significance in the relationship (kayshap et al. 2010, and miles et al., 2011). a number of points should be made about this analysis, however:

• The regression results themselves are not uniform. kayshap et al. (2010) ran three specifications and found in one that “the coefficient on the equity-to-assets variable is large and statistically significant. The point estimate of 28.31 implies that a one percentage point increase in the ratio of equity-to-assets is associated with a 28 basis point increase in the cost of loans” (page 20). They then reject this effect to be “too big to make economic sense.”

• using past data on realized capital ratios is not the same thing as assessing the impact of changes in future required capital ratios. bank capital ratios typically have been an endogenous response by the banking sector seeking to optimize risk and reward against the backdrop of economic conditions that are viewed as more or less risky. at times of economic weakness and volatility, realized capital ratios might be expected to rise, as banks turn more defensive, while lending rates and spreads would decline as the demand for credit weakens in line with the economic cycle. historically, banks were also able to sustain higher capital ratios without higher lending rates since deposit funding was typically much cheaper. as competition for deposit funding becomes more aggressive under the new basel iii liquidity requirements, this offset is unlikely to prevail.

• as noted above, banks might not use lending rate adjustment as the sole or even primary adjustment mechanism to tighter conditions, including those that involve a rise in aggregate funding costs associated with higher capital requirements. They instead might choose to impose tighter credit standards on lending, which might lead to effective credit rationing of smaller and/or less creditworthy borrowers.

The market in bank equity has undergone a dramatic transformation in the past few years. from the middle of the 1990s through to the middle of the 2000s, banks’

core intermediation businesses were seen as offering an attractive combination of higher returns at lower risk. The combination was an extremely attractive mix to equity investors, who were willing to allocate an increasingly large proportion of their portfolios to the banking sector. in retrospect, the combination of higher returns and lower risk was unsustainable. inarguably, bank equity investors and bank managers were not the only ones to misread the extent to which the phase through the middle years of the last decade represented a genuine, durable reduction in economic uncertainty (see, for example, bernanke 2004).

Crucially, however, the devastating collapse in confidence in the stability of the intermediation process that culminated in 2008Q4 (especially with regard to maturity transformation), combined with official sector policy shifts—both to punish reckless bank behavior and tighten future regulation, as well as to flatten the yield curve and force banks to allocate more to “safe” lower-yielding short-term assets—led to banks becoming perceived by equity investors as now offering a relatively unattractive combination of low returns at high risk. banks have also become far more vulnerable due to rising fiscal solvency risks in mature economies. This has been most evident in the euro area in recent quarters. This vulnerability will be increased by new liquidity requirements designed to raise banks’ exposure to official sector debt.

This dramatic shift in equity market conditions facing banks can be seen by comparing price-to-book ratios for national banking systems (Chart 4.2, next page). The price-to-book ratio shows the value to be attached to a banking business. when the ratio is well above one, then the equity market is willing to pay a premium for the assets owned by a bank. when it is below one, investors would be better off buying the underlying assets than the bank itself.

in 2000-07, price-to-book ratios averaged 2.28 in the united states, 2.11 in the euro area, and 1.74 in Japan, where deep concerns about the banking system through 2003 gave way to greater optimism in 2004. since the beginning of 2009, price-to-book ratios have averaged 1.12 in the united states, 0.86 in the euro area and 0.83 in Japan. The average investor in euro area bank equity could, in principle, pick up 13 percent by buying the representative assets of a bank, and shorting the bank stock. in this sense, it seems self-evident to say that the current cost of issuing equity is very high.

it should also be noted that investors in bank equity face two other uncertainties, which cloud the picture and are liable to make them somewhat leery of investing significant amounts in bank equity on anything other than very attractive terms:

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• Considerable ongoing regulatory uncertainty remains. although there was an encouragingly rapid conclusion to the first phase of the basel iii process, and a welcome extension of the horizon over which banks will be required to build higher capital ratios, the official agenda has now shifted rapidly to items that will not only compound this regulatory burden (e.g., capital surcharges on systemically important banks), but which also add considerable uncertainty to the business environment in which banks operate. new restrictions on what banks can and cannot do, as well as threats to break up large, diversified banking groups raise considerable unknowns for investors in bank equity. This includes the threat formulated by regulators to restructure or downsize banks that cannot design some rather undefined “credible” resolution plans. The new world of low-for-long interest rates and likely persistently weak credit demands also raises big unknowns about the outlook for (pre-tax) banking sector profitability. moreover, banking is now seen as an attractive source of tax revenues, leaving investors very uncertain as to the post-tax returns that they can enjoy, even assuming some clarity on pre-tax earnings. finally, restrictions on bank dividend payouts mean that investors in bank equity are now forced to rely more on capital gains as a means of generating returns.

• substantial public sector holdings of bank equities persist in a number of countries, reflecting an equity overhang that will make new private sector investors leery of adding to exposures until these holdings are sold.

4.4 re-priCing BanK DeBtThe impact of regulatory reform on bank bond funding costs is somewhat more straightforward: the impact of reform would be to raise bank spreads in the bond market; an alternative way of expressing this is that a lower amount of demand for bank bonds will be forthcoming from investors at any given spread than in the past. This spread-increasing effect operates through three main channels:

• Regulatory reform is partly aimed at making bank bondholders bear more risk. for example, policymakers have made commitments that the support and guarantee systems that shielded bond investors in 2008-09 will not be repeated. moreover, plans are also being developed to design mechanisms to allow for “bail-ins” of more bond investors such that their holdings are converted to equity at times of stress, including senior debt. basel already requires all debt instruments that count as Tier 1 or Tier 2 capital to include write-down or conversion features to be triggered at the point of non-viability and these new proposals would extend the securities at risk for such conversion further up the capital structure. it remains true that if the absence of such bailing out structures were to translate in an out-failure, then the risk for bond holders would be smaller.

• as noted, liquidity requirements are liable to significantly increase the demand for long-term bond funding from banks for two reasons. first, higher required holdings of liquid assets under the lCR will need to be funded. as noted, we assume that term

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Chart 4.2

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wholesale markets will be used to raise this funding. note that this assumption is much less burdensome on the economy than an alternative, which is that illiquid (private sector) credit would be one-for-one crowded out by higher holdings of liquid assets (government debt). second, the nsfR implies the need for banks to replace short-term wholesale liabilities with long-term debt liabilities. note that the two requirements will eventually need to be met simultaneously. The higher holding of long-term debt needed to fulfill the nsfR will help meet the lCR, with the effect of mitigating the upward pressures on funding costs.

• finally, there are some reforms under way affecting investment firms that are quite likely to reduce the demand for bonds issued by the banking sector. for example, european insurance companies will find it more costly to hold both bonds and equity issued by banks under the new solvency ii legislation, scheduled for introduction at the beginning of 2013.

offsetting these spread-raising effects is the likelihood that higher capital requirements will provide more of a solvency buffer for bond holders, thus (all other things equal) reducing the riskiness of their holdings.

The empirical challenge for our cumulative impact framework is how best to quantify these various effects. The approach that we have taken to date, which has also been adopted in other work such as that undertaken by the bis macroeconomic assessment Group, is to add an extra amount to the spread paid on bank bonds through the relevant projection horizon.

Certainly, recent evidence on bank bond spreads is fairly compelling, with average global spreads on

bank debt rising by about 100 basis points in the past four years (Chart 4.3, this page). using equation (2) in section 3 as a benchmark and then applying the actual increase in spreads on bank bond debt observed between 2006-07 and 2010, then bank lending rates would have risen by about 39 basis points in the united states, 18 basis points in the euro area, and 3 basis points in Japan due to this bond re-pricing effect.

There are problems, however, with the approach of adding a specific amount to spreads to make up for the higher risks to be associated with bank bonds under a regime of regulatory reform. Three stand out:

• it is hard to know how much of a spread increase is warranted purely as the result of regulatory change versus the general increase in bank risk resulting from the events surrounding the financial crisis. as was noted in the discussion of bank equity, the financial crisis was a watershed event, as it revealed to all financial market participants — but especially investors in bank funding instruments — how much more risky banking sector debt intermediation was relative to earlier experiences and perceptions. as a result, debt issuance will be more expensive for banks independent of tougher regulatory reform.

• as with equity, increased debt issuance (possibly because of tougher liquidity requirements) will plausibly lead to higher spreads, with the exact extent of the spread increase determined by the size of the increase in issuance.

• higher equity ratios should provide some offsetting relief, as they would provide a greater cushion against debt default.

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54 see, for example, ingves (2011), page 13. note that mr. ingves (Governor of the Riksbank) has recently been named Chairman of the basel Committee on banking supervision (bCbs).

seCTion 5: esTimaTinG The CosTs of ReGulaToRy RefoRm: Gdp and employmenT foReGone

To generate estimates of the costs of regulatory reform of the banking system – in terms of near-term output and employment foregone – we compute paths for a number of key macroeconomic variables for five major, mature economies: the united states, the euro area, Japan, the united kingdom, and switzerland. we do this by applying the assumptions about regulatory reform shown at the end of section 1 into our banking models, which are extended versions of the framework outlined in section 3, and then by taking the key output variables from those banking models – specifically, lending rates and bank credit growth to the private sector – and feeding them into a global econometric model to generate paths for real GDp and employment.

in the base scenario path, we assume that the regulations prior to 2008-09 – in the form of capital ratio requirements and definitions – are maintained. we then compare the macroeconomic outcomes from this path to those generated by a number of reform scenarios, and characterize the difference between the two as measuring the macroeconomic impact of reform.

in contrast to our Interim Report, where we focused on a single, central reform case, we have now produced explicit 2011-20 paths for real GDp and employment for three reform scenarios, compared to a neutral baseline of no reform.

• The core regulatory reform scenario is one in which we assume all reforms will be implemented according to specified timetables or, where no timetable has yet been specified, on a path that iif staff judges to be appropriate. we use our standard core equity shadow price model in this scenario (see section 5.2).

• The favorable capital markets scenario is one in which we use the same timetable for regulation as in the core, but amend our bank equity and debt funding models to produce very generous and elastic funding conditions. This scenario produces (by assumption) less negative implications, as lending rates are lower and credit availability is higher.

• The rapid adjustment scenario is one in which we assume that market participants anticipate

higher standards scheduled to be adopted later in the decade and adjust rapidly (i.e. over the 2011-12 horizon). This more rapid adjustment could be the result of one or more of three sets of factors combining: (a) investors – especially equity investors – might put pressure on banks managers to hit projected future requirements soon, especially in a nervous de-leveraging environment in the mature economies; (b) banks that are able to move ahead rapidly on raising standards might choose to do so quickly as a way of signaling comparative strength. in so doing, these leaders might force other, weaker banks to respond for fear of sending investors an adverse signal; and (c) some regulators are very eager to push for higher standards earlier.54 This could then spark a wave of reaction from regulators in other jurisdictions seeking not to be seen by their local politicians as “going soft” on banks. This rapid adjustment scenario would produce a short, sharp reaction bordering on a recession.

5.1 Step 1: aDDitionaL BanK funDing reQuirementSThe first step in our framework is to estimate the additional bank funding requirements associated with tougher regulatory requirements. These funding requirements are illustrated in Table 5.1, which shows the additional net capital (core equity) and net long-term debt requirements for aggregate banking systems in the five jurisdictions through 2015 and 2020.

funding requirements differ across each our three scenarios. although the capital ratios to be achieved by banking systems are the same in our central and benign funding scenarios, the former generally includes a lower path of credit growth than the latter, implying lower absolute funding needs. by assumption, funding needs are more burdensome through the early years of the scenario in the rapid adjustment case.

The magnitude of these funding needs is inevitably shaped by the specific assumptions that we make about how the banking system, in aggregate, adjusts to higher capital and liquidity requirements:

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55 as discussed in section 4, conditions prevailing in capital markets for bank funding instruments are critical to determining how bank funding costs will respond to higher issuance requirements.

• we assume that banks adjust to higher capital ratios by raising net new capital, either through retained earnings or net new market issuance. we further assume that banks fund any acquisition of safe assets needed to meet liquidity ratio requirements through the net issuance of long-term debt. in shifting their sources of funding in this way, banks will then face a higher overall cost of funding, which they will then pass on to borrowers in the form of a higher lending rate.55

• we do not simply assume that banks can or will choose to raise all the capital that would be implied by the application of new regulation for capital to the existing risk asset base. instead, we assume that banks limit the absolute increase in core Tier 1 capital – resulting from either the retention of post-tax issuance or net new issuance to private investors – to an amount that we judge that private

markets can sustain at a reasonable cost (using our shadow price of equity model; this is discussed in more detail below). in so doing, banks will be forced to limit risk-weighted asset growth, through some combination of limiting total assets held and by skewing more of those holdings to “safe” assets with a low risk weighting. in official sector parlance, this amounts to banks changing their “business models”; in the real world, it amounts to de-leveraging, with an emphasis on squeezing credit to more risky borrowers.

• The assumption that banks will limit asset growth leads to significantly lower net demands for long-term debt issuance than we had previously projected. This is because net long-term debt funding is assumed to be the residual in the balance sheet for our banking models, so lower asset growth translates directly into lower net debt growth.

Table 5.1: Additional (from 2010) Bank Funding Requirements (billions of local currency units – trillions for Japan; aggregates in US dollars; all scenarios are expressed as differences from end-2010 levels.)

US Euro Area Japan UK Switzerland Total

Base scenario

Bank Capital 2015 98 249 1 -1 4 479 2020 220 563 4 78 8 1,229

Long-term debt 2015 123 248 1 23 -5 521 2020 155 330 0 30 -5 683

Central and benign funding scenario

Bank Capital 2015 260 728 15 137 50 1,785 2020 290 829 18 146 70 2,044

Long-term debt 2015 216 329 5 26 12 816 2020 417 670 5 47 10 1,544

Rapid adjustment scenario

Bank Capital 2015 209 731 15 127 46 1,724 2020 243 826 18 160 66 2,013

Long-term debt 2015 222 381 5 36 12 913 2020 413 670 5 42 10 1,532


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• To derive the estimates in Table 5.1, it is necessary to make one additional assumption that attracts surprisingly little discussion in the literature. This relates to the assumption of what national buffers over regulatory minima are likely to be maintained by banks and enforced by local regulators in the years ahead under the new basel iii regime (i.e., pillar 2 requirements). Current buffers – defined as the difference between actual core capital ratios

and current regulatory minima – are in some cases quite wide, and this probably reflects a combination of supervisory guidance and market pressure. in such cases, simply extending those buffers forward would seem to be a too conservative assumption. in our projection work, we have thus made a series of assumptions about national buffers that reflect what we believe to be a pragmatic combination of regulatory minima and supervisory add-ons.

Chart 5.1 Cumulative Contribution to Changes in Core Tier 1 Equity, 2011-15 Change in Core Tier 1 equity from end-2010 levels

-100

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Net new issuance to private investors

Retained earnings Public disinvestment and redefinition effects

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56 note that this increment is relative to end-2010 levels, not relative to the base scenario.57 in our projections, we assume that there are net sales of bank equity by the public sector in the euro area, united states and, especially, the united

kingdom (specific amounts and timing assumed).58 some industry estimates for debt issuance are much higher, reflecting the assumption that banks’ business models will be largely unchanged. for example,

see samuels et al. (2010), which estimates that european banks will face a €3 trillion funding shortfall to meet the proposed basel iii liquidity rules.

by 2015, banks are projected to need to raise about $1.8 trillion, net of equity capital.56 based on our models, as much as $2.1 trillion of equity could be created by banks retaining a relatively high share of earnings over this time frame (see Chart 5.1, previous page). offsetting this gain, about $520 billion of Tier 1 equity would be eroded by a combination of the first phase of redefinition effects and sales of equity by the public sector.57 This would leave a relatively modest amount – only $240 billion – to be raised through net new issuance to the private sector in 2011-15. we believe that it would be a mistake, however, to assume that because retained earnings could account for the lion’s share of new capital accumulation that this somehow makes that capital cheap, or easy, to raise from a shareholder perspective. indeed, in our shadow pricing model (discussed below) it makes no difference as to whether capital is raised by net new issuance to shareholders, or by retained profits. bank shareholders who find that the profits are ploughed back into the company, rather than returned to them in cash are apt to seek adequate returns in the form of potential for stock appreciation (either in the banking sector or, quite plausibly, elsewhere). This would likely put downward pressure on bank stock prices every bit as much as would net new issuance to new investors.

moreover, the relatively high amounts of capital that can be raised (in our models) through profit retention over the next five years are the result of two factors. first, bank profitability is boosted by the higher lending

rates and net interest margins that drop out of our bank equity shadow price model (see below). second, they also reflect an assumption of much higher profit retention ratios under the regulatory scenario than under the base scenario (see Chart 5.2). in our base scenario, we assume that banks retain about 19 percent of post-tax profits over the next decade. in our core regulatory change scenario this increases to 58 percent.

long-term net debt funding requirements are also likely to be substantial, at $826 billion through 2015 and $1.5 trillion through 2020, of which about $670 billion is accounted for by banks in the euro area.58

The debt funding estimates in Table 5.1 are derived mainly as a result of the banks’ need to meet the new liquidity requirements under basel iii. because these kick in later in the decade, debt funding needs rise more progressively than capital needs. To meet the nsfR requirement, banks increasingly have to issue long-term debt for other liabilities. moreover, to fund the necessary increase in liquid assets required to meet the lCR, we assume that banks issue more debt in long-term wholesale markets.

it is, of course, possible that banks will choose to meet the requirement to hold more liquid assets by shedding other assets – especially private sector credit. This would, in our view, represent a severe credit crunch on private sector credit that would produce far more serious (and difficult to model) negative implications for economic growth and employment than described below.

Chart 5.2

10% 13%

25% 28%

21% 19%

38%

68% 63%

75%

47%

58%

United States Euro Area Japan UK Switzerland Average

Profit Retention Ratiosshare of post-tax profits retained as capital, average 2011-20

Base scenario

Central scenario


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59 we use the term “shadow price” specifically because it is an unobservable price. note that it is not the same as the realized rate of return on equity for two reasons. first, it is set with regard to the outcome of last period’s key variables in equation (3). second, we constrain the shadow price by limiting the amount of equity that the banking sector builds in each year.

60 presumably, this will show up in a cheapening in bank equity prices (see Chart 4.2, page 47).61 note that this experience mirrors that of 2008-10, when banks adjusted to the need to boost capital in adverse funding conditions both by raising

lending spreads and sharply cutting back on credit availability.

5.2 Step 2: mapping theSe funDing reQuirementS into LenDing rateSThe implications of these changes in regulation for bank lending rates to the private sector are illustrated in Table 5.2. These results are essentially derived from a model similar to that of equation (2) on page 39. higher real lending rate outcomes are the result of the combination of the shifts in the blend of funding and assets undertaken by banks, with the shifts in the cost of funding resulting from increased issuance pressures.

in applying equation (2), we use a model of what we call the shadow price of bank equity as the return on equity (Roe) component of the first term. This model – summarized in equation (3) – combines the various features that we believe shape the cost of equity, from the banking sector’s perspective. it can be thought of as that internal pricing rate that a bank’s capital allocation department charges the various business units when pricing the use of capital.59 in turn, those business units then have to build that capital charge into their own lending rates:

Roeshadow = Target Roe + ß1 * (Growth rate of core Tier 1 equity – nominal GDp growth)t-1 + ß2 * (Target Roe – Realized Roe)t-1 + ß3 * (Core Tier 1 capital ratio – 7%)t-1 (3)

This model combines the various influences on the cost of bank capital that have been identified in the literature (and which were discussed in section 4, on pages 43-48):

• The constant term in the equation (the “target” Roe) is country specific, reflecting different national structures and preferences. for the united states, this constant is set at 10 percent; for the euro area at 7.5 percent; for Japan at 5 percent; for the united kingdom at 9 percent; and for switzerland at 7.5 percent.

• The second term is one that captures the effects of higher near-term supply in raising the marginal cost of capital. we assume that equity investors’ portfolios grow in line with nominal GDp. we further assume that investors need to be compensated in order to allocate their portfolios toward banks, so any growth in capital at a pace faster than nominal GDp will be costly to banks as it occurs.60 hence we assume ß1 > 0.

• The third term is a penalty/reward term that means that a corrective process is established so that any deviation from the target Roe in one year will be offset by actions to affect the shadow equity price – and, thus, the chosen lending rate – in the next. for example, if the realized Roe falls short of target, then the shadow Roe is raised and this leads into a higher lending rate. Therefore, we set ß2 > 0.

• The fourth term can be called a “modigliani-miller” (m-m) term. for each percentage point that bank core capital exceeds what is now widely viewed as a “safety” minimum (7 percent), banks enjoy a lower cost of capital. we thus assume ß3 < 0.

• in the base scenario, the coefficients in the model are each assigned an absolute value of 0.5, with the exception of the m-m term, which is set at 0.25. in the benign funding scenario, these coefficients are set at 0.1.

This model has the benefit of combining short-run adjustment challenges with appealing longer-term characteristics. if reforms are implemented more slowly (i.e., the required growth rate of core Tier 1 equity is moderate), then the increase in the lending rate is muted. once a steady state has been achieved (i.e., the second and third terms in the equation are zero), then the model has straightforward m-m properties: higher capital makes the banking system safer and lowers Roeshadow and, thus, bank lending rates.

equation (3) is applied in our models with just one additional constraint imposed: we do not allow the increase in Roeshadow to become excessive in any projection period. we do this by constraining the rate of growth of core Tier 1 equity to a rate that ensures that the shadow equity price – and, thus, the bank lending rate – does not become implausibly high. in such a period when bank capital is effectively rationed, banks pass through some of the impact of higher regulation, which is the source of the increase in core Tier 1 equity, into reduced credit to the private sector.61 in this way, our banking sector models generate both higher lending rates and lower credit supply.

based on this framework, the net result of reforms is to increase real bank lending rates to the private sector by a (weighted) average of 364bps over the next 5 years and by 281bps over the next decade. This increase would be greatest in the united kingdom and least in switzerland. The near-term increase in bank lending

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54

rates in the united states would be more significant than in the euro area, as the full impact of Dodd-frank and other reforms scheduled for 2012-14 are felt. but this relative impact would reverse later in the decade. The increase in Japanese rates would be quite significant relative to the current low level of lending rates to the private sector.

it is worth dwelling on a few other aspects of this increase in interest rates. first, it will be hard to offset any rise in private sector lending rates with a reduction in official rates, since they generally remain close to zero. second, most central banks have been emphasizing the relative frailty of their economies and the fact that they are not in good enough shape to absorb the impact of higher interest rates. This is presumably relevant no matter what the source of that rate increase. Third, this tightening in financial conditions occurs against the backdrop of fiscal worries in all the major economies (with the conspicuous exception of switzerland, where the tightening in financial conditions resulting from reform is not that material). in such an environment of sustained efforts to reduce public sector leverage, it would seem desirable to temper rather than accelerate the forces of de-leveraging in the private sector.

There are some other aspects of note in our results as they relate to banks’ financial performance. because lending rates are higher in the reform scenarios, banks end up being more profitable; indeed, this is an important way through which they raise capital. The outturn for the rate of return of equity is also often – but not always – higher. This is the logical outcome of the way our model works – investors in bank equity need to be induced to hold higher amounts.

5.3 Step 3: traCing the reaL eConomy impLiCationS of tighter finanCiaL ConDitionSThe real GDp (and employment) implications of the change in financial conditions can then be traced by feeding higher aggregate lending costs and reduced credit supply into a macroeconometric model. The tightening in credit conditions associated with the lesser increase in real bank lending rates and reduced credit supply needs to be combined with the (lesser) increase in lending rates from non-bank sources to produce an overall financial shock to be imposed on the economy. These linkages are highlighted in Chart 5.3.

Table 5.2: Tightening in Credit Conditions to the Private Sector period average in basis points (lending rate) or percentage points (credit growth); overall average is GDP-weighted; all scenarios expressed as differences from the base scenario

US Euro Area Japan UK Switzerland Average

Real lending rate

Central scenario 2011-15 468 291 202 548 93 364 2011-2020 243 328 181 568 40 281

Benign funding scenario 2011-15 293 92 99 106 40 177 2011-2020 190 178 109 28 1 160

Rapid adjustment scenario 2011-15 569 285 195 744 98 416 2011-2020 286 321 179 532 43 294

Credit growth

Central scenario 2011-15 -4.6% -5.2% -4.6% -5.6% -0.9% -4.8% 2011-2020 -1.9% -4.2% -2.8% -4.6% -0.3% -3.0%

Benign funding scenario 2011-15 -3.7% -4.4% -3.8% -3.4% -0.1% -3.9% 2011-2020 -1.7% -3.8% -2.4% -1.7% 0.0% -2.5%

Rapid adjustment scenario 2011-15 -5.4% -5.2% -4.3% -6.1% -1.4% -5.1% 2011-2020 -2.2% -4.2% -2.8% -4.3% -0.5% -3.1%


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62 niGem is structured around the national income identity, can accommodate forward-looking consumer behavior and has many of the characteristics of a Dynamic stochastic General equilibrium (DsGe) model. unlike a pure DsGe model, however, niGem is based on estimation using historical data.

63 see bayoumi and melander (2008) and Cappiello et al. (2010) for examples of alternative approaches to modeling macro-financial linkages.

in our Interim Report, we used reduced-form relationships to map from higher rates through reduced credit supply to nominal GDp and, finally, real GDp. for this report, we have amended this approach, choosing instead to use the global macroeconometric model of the uk’s national institute of economic and social Research (niesR), niGem, as the primary mechanism for mapping the broader economic effects.62

niGem does not have an explicit banking sector, so we use our own models in conjunction with niGem to map the combination of higher lending rates and tighter credit supplies. we do this by increasing the spreads that consumers and companies are charged on the funds they borrow to finance their activities, combined with an exogenous reduction in consumption and investment that we assess as the appropriate impact of reduced credit supply (see appendix 5.1).63 note that we have also turned off the monetary policy response function in niGem. by using niGem, in conjunction with our own detailed banking models, we hope that we have achieved the best of both worlds: a sufficient degree of complexity in both banking sector and macroeconometric modeling, so as to capture all necessary linkages. our results remain subject to the fact that there could well be shortcomings in either or both of the modeling frameworks that we use.

with this health warning in mind, the results from our core regulatory reform scenario are shown in Table 5.3 (next page). in summary, the impact of reform is to reduce the average GDp growth rate of the five jurisdictions by about 0.7 percentage points per year over the next five years (on average), which leaves the level of real GDp about 3.2 percent below where it would otherwise be. The effects are significant across

all the major economies, including Japan, which was the economy least affected by the crisis, but which is apt to pay a significant price to meet new regulatory requirements – assuming, of course, that they are implemented in full there. The impact on switzerland is also significant, although we suspect that a significant component of this reflects spillover from weakness in the euro area.

The near-term (five year) impact on the uk economy is also significant – about 0.8 percentage points per year – and exceeds that in the euro area, which is consistent with the fact that the united kingdom will apply all changes applicable to the euro area, but also some of its own which adds somewhat to the degree of restrictiveness.

The us economy is likely among the major economies to experience the smallest growth reduction resulting from regulatory reform. This is especially true once the projection horizon is extended to 2020. This more moderate effect results from two points highlighted at the start of this study (see Chart 1.1). The us banking system has less distance to adjust to new regulatory norms than those systems in most other jurisdictions (especially with respect to capital), and the banking system accounts for a smaller share of debt intermediation than in most other jurisdictions. That said, the employment implications of weaker near-term us growth are not encouraging, and our work shows that us employment will be about 2.9 million lower in 2015 than would otherwise be the case, as a result of the restrictions flowing from financial reforms. in our opinion, the job disappointments of the past year reflect the first part of this jobs shortfall.

The employment implications of the financial reform agenda, which flow directly from the growth

RegulatoryChange

Impacton banks

Impact onnon-bank creditintermediation

Lowercredit supply

Higher banklending rates

Highernon-bank

lending rates

Higherprivate sector

borrowingcosts

Loweraggregatedemand

Chart 5.3 Tracking the Real Economy Implications of Reform

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implications noted above, are significant across all the major economies, at least through 2015, which is the horizon over which most governments would most like to make a dent in the 17 million employment loss registered between the pre-lehman peak in 2008Q3 and the global employment trough in 2010Q1 (Chart 5.4).

we also consider the implications of reform under a favorable funding markets scenario (Table 5.4). The main feature of this scenario is that all additional funding

requirements resulting from higher regulatory norms can be met in the marketplace at fairly elastic terms. This can thus be viewed as our “optimistic” scenario. in this scenario, average growth in the mature economies would be about 0.3 percentage points lower per year than in the base scenario, which is half of the reduction experienced in the core reform scenario. we would not see this scenario as implausible: rather it would be the scenario that would prevail should bank funding markets return to anything like the buoyancy that they enjoyed

Table 5.3: Change in Real GDP and Employment – Core Regulatory Change Scenario overall average is GDP-weighted; all scenarios expressed as differences from the base scenario

US Euro Area Japan UK Switzerland Average/Total


2011-15 annual average -0.6% -0.6% -0.8% -1.1% -0.8% -0.7% 2011-2020 annual average -0.1% -0.4% -0.3% 0.0% -0.3% -0.2%

Real GDP level

2015 -2.7% -3.0% -4.0% -5.5% -3.7% -3.2% 2020 -1.1% -3.9% -3.4% -0.5% -2.9% -2.4%

Employment growth (percentage points)

2011-15 annual average -0.7% -0.4% -0.2% -0.8% -0.7% -0.5% 2011-2020 annual average -0.1% -0.3% -0.1% -0.1% -0.3% -0.2%

Employment loss (‘000)

2015 -2,886 -2,825 -485 -1188 -149 -7,533 2020 886 -4,012 -400 -414 -145 -4,084


Chart 5.4

400

405

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415

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430

08Q2 08Q3 08Q4 09Q1 09Q2 09Q3 09Q4 10Q1 10Q2 10Q3 10Q4 11Q1

17 million jobs

Employment in the Major EconomiesUnited States, European Union (27) and Japan, million

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before mid-2007. whether or not this is happening can be tracked with reference to variables such as those in Charts 4.2 and 4.3 (see pages 47 and 48, respectively).

finally, we also project an accelerated adjustment scenario (Table 5.5), in which banks load much of the adjustment due over a multiyear period into 2011-12.

Table 5.4: Change in Real GDP and Employment – Favorable Capital Markets Scenario overall average is GDP-weighted; all scenarios expressed as differences from the base scenario



2011-15 annual average -0.4% -0.3% -0.3% -0.3% -0.1% -0.3% 2011-2020 annual average -0.1% -0.3% -0.2% 0.0% 0.0% -0.2%

Real GDP level

2015 -1.8% -1.4% -1.7% -1.5% -0.5% -1.6% 2020 -0.8% -2.9% -1.7% 0.4% 0.1% -1.6%


2011-15 annual average -0.5% -0.2% -0.1% -0.2% -0.1% -0.3% 2011-2020 annual average -0.1% -0.2% 0.0% 0.1% 0.0% -0.1%


2015 -1,108 -1,240 -202 -298 -21 -2,864 2020 1,109 -3,034 -200 161 2 -1,963


Table 5.5: Change in Real GDP and Employment – Accelerated Adjustment Scenario overall average is GDP-weighted; all scenarios expressed as differences from the base scenario




Real GDP level

2015 -2.7% -2.5% -2.6% -3.7% -5.7% -2.7% 2020 -1.5% -4.1% -3.3% -1.2% -4.5% -2.7%




2015 -2,908 -2,630 -305 -1,135 -243 -7,221 2020 526 -4,356 -383 -504 -220 -4,937


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58

64 see hervé et al (2010).65 The oeCD ready-reckoners are based on a permanent increase in rates. To proxy this, we use the 10-year average increase in real lending rates for each

of the G3 countries that comes out of our model (as shown in Table 5.2).

as noted, any estimate of the impact of reforms will be model specific, and our macroeconomic results are dependent, in part, on the specifics of niGem, which is the only full-scale macroeconometric model to which we have access.

as a cross-check to the plausibility of niGem’s results, however, we can use ready-reckoners derived from other established models. for example, the oeCD has provided benchmarks as to how its global model can be used to proxy the impact of higher lending rates.64

using ready-reckoners provided by oeCD economists to estimate the impact of a 100bps increase in short-term interest rates in each of the G3 countries on both a specific country and other G3 economies, it is possible to map the estimated increase in lending rates in each jurisdiction caused by the regulatory reform agenda into a five year GDp-level impact (Chart 5.5).65 in this case, the combined impact on the G3 economies – about 2.7 percent of real GDp foregone over a five year period – is quite similar to the result produced by niGem (Table 5.3).

Chart 5.5

-3.5

-3.0

-2.5

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Year 1 Year 2 Year 3 Year 4 Year 5

United States

Japan

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3.0%

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Impact of Regulatory Reform on the Level of G3 Real GDP Using OECD Model Benchmarks percent deviations from baseline


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The banking model described in section 3 of this Report provides a simple, clear framework for mapping the effect of regulatory changes on two types of credit shocks: a shock to the price of credit and a shock to the amount of credit extended by banks to the private sector.

in this appendix, we provide details of how these two shocks are implemented in niGem at the scope of computing the real economy impacts in terms of real GDp and employment foregone.66 The two sets of shocks are simulated by running a stacked simulation that first involves implementing the credit price shock and then adding the credit quantities shock to the first simulation solution.

Credit price shock.The first shock consists of an increase in the spread over the reference rate that banks charge to private sector borrowers (companies and households). under the assumption of no monetary policy reaction used in our analysis, companies and households see a rise in the rate they are charged on their bank borrowing as effect of the enhanced regulation.

in niGem, the rate at which companies are able to borrow to finance their investment projects is assumed to affect their cost of capital and therefore their investment plans. such “user cost of capital” is modeled as a function of the real interest rate and two spreads, an investment premium (ipRem), and an equity risk premium (pRem). in implementing the credit price shock, both of these spreads are increased by the amount that the real rate rises as effect of regulatory reforms in the banking sector model.

in niGem, households are assumed to be able to borrow from banks against a range of assets. The borrowing cost is defined as the sum of a reference rate and a spread (lenDw). a rise in borrowing costs negatively affects consumption decisions. in implementing the credit price shock, we increase the spread consumers are charged by banks by the amount the real rate increases as effect of regulatory reforms in the banking sector model.

Shock to credit quantity.we proxy the reduction in credit quantity induced by the regulatory reforms with the percentage reduction in Rwas obtained by imposing a ceiling on core Tier 1 capital growth. we make the assumption that a reduction in credit affects one-to-one consumption and investment decisions. in other terms, we simulate the effect of the credit crunch in niGem by exogenously reducing consumption and investment by half of the size of the credit crunch. That is, we assume that the credit quantity shock is equally distributed between consumption and investment.

in niGem, a credit crunch shock would only affect consumers who are not credit constrained. for them, the consumption decision is based on the level of permanent income, rather than the level of disposable income as is the case for the credit constrained consumers. we therefore implement the consumption shock as a (multiplicative) exogenous shock to permanent income (the human wealth variable, hw).

The impact of a credit crunch on investment is implemented in the form of a reduction in the capital stock. business investment in niGem is defined from the capital accumulation equation. some simple algebra allows deriving the (business) capital stock shock (shock to the variable kb) necessary to obtain the desired impact of the credit crunch on investment (under the model assumed depreciation rate, δ).67

appendix 5.1: TeChniCal deTails on implemenTinG CRediT TiGhTeninG in niGem

66 The simulations were run on niGem version 1.11. we gratefully acknowledge niesR staff for their guidance and technical support. we remain solely responsible for any errors.

67 shock to capital KB (1 - δ) * shock to capital(-1) + IB(base) / KB(-1)(base) * shock to investment –––––––––––––––– -1 = –––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––– KB(base) (1 - δ) + IB(base) / KB(-1)(base)

NiGEM Variables Shocked Calibration of Shocks

Price of credit shock LENDW Increase in the real IPREM rate from banking model PREM

Credit quantity shock HW Reduction in RWAs KB from banking model

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60 The following tables summarize the results from our three scenarios in more detail. full printouts of the banking models and macroeconomic results are available from the institute of international finance on request ([email protected]).

Country Pages

United States 61-63

Euro Area 64-66

Japan 67-69

United Kingdom 70-72

Switzerland 73-75

appendix 5.2: iif CumulaTive impaCT models: CounTRy ResulTs in deTail

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e= estimate; p = projection

IIF MACRO BANKING DATABASE: UNITED STATES SCENARIOS COMPARED Avg or Avg or total total 2010e 2011p 2012p 2013p 2014p 2015p 2016p 2017p 2018p 2019p 2020p 11-20 11-15

EFFECTIVE REGULATORY CAPITAL RATIOBase 15.0% 14.8% 14.6% 14.3% 14.1% 13.8% 13.6% 13.3% 13.1% 12.8% 12.6% 13.7% 14.3% Core Regulatory Change 15.0% 14.8% 16.1% 16.3% 18.1% 17.3% 16.4% 15.5% 14.6% 14.4% 14.1% 15.8% 16.5% Accelerated Adjustment 15.0% 18.8% 18.6% 18.3% 18.1% 17.3% 16.4% 15.5% 14.6% 14.4% 14.1% 16.6% 18.2%

Differences over base scenario (percentage points) Core Regulatory Change 0.0% 0.0% 1.5% 2.0% 4.0% 3.4% 2.8% 2.2% 1.5% 1.5% 1.5% 2.1% 2.2% Accelerated Adjustment 0.0% 4.0% 4.0% 4.0% 4.0% 3.4% 2.8% 2.2% 1.5% 1.5% 1.5% 2.9% 3.9%

COMMON EQUITY RATIOBase 11.8% 11.6% 11.4% 11.2% 11.0% 10.8% 10.6% 10.4% 10.2% 10.0% 9.8% 10.7% 11.2% Core Regulatory Change 11.8% 11.6% 12.9% 13.2% 15.0% 14.2% 13.4% 12.5% 11.7% 11.5% 11.3% 12.7% 13.4% Accelerated Adjustment 11.8% 15.6% 15.4% 15.2% 15.0% 14.2% 13.4% 12.5% 11.7% 11.5% 11.3% 13.6% 15.1%


COMMON EQUITY ($ billion)Base 986 1,000 1,020 1,042 1,064 1,085 1,108 1,132 1,157 1,182 1,206 Core Regulatory Change 986 969 1,079 1,129 1,291 1,246 1,217 1,205 1,191 1,234 1,276 Favorable Capital Markets 986 972 1,099 1,167 1,348 1,304 1,269 1,247 1,224 1,264 1,305 Accelerated Adjustment 986 1,291 1,258 1,246 1,231 1,195 1,170 1,157 1,142 1,185 1,229

Differences over base scenario Core Regulatory Change 0 -31 59 87 228 161 110 73 33 52 70 Favorable Capital Markets 0 -28 79 126 284 219 161 115 67 83 99 Accelerated Adjustment 0 291 238 205 167 110 63 25 -15 3 23

COMMON EQUITY GENERATION REQUIRED FROM PRIVATE SECTOR ($ billion, new issuance and retained profits)Base 258 23 21 21 22 21 23 24 25 25 25 230 108 Core Regulatory Change 258 -8 110 50 201 -7 10 26 24 43 42 491 346 Favorable Capital Markets 258 -4 127 68 219 -5 3 17 16 40 41 520 404 Accelerated Adjustment 258 315 -33 -12 23 3 13 25 23 43 44 444 295

Differences over base scenario Core Regulatory Change 0 -31 90 29 179 -28 -13 2 -1 19 18 261 238 Favorable Capital Markets 0 -28 106 47 197 -27 -20 -7 -10 15 16 290 296 Accelerated Adjustment 0 291 -54 -33 1 -18 -10 1 -2 19 20 214 187

LONG-TERM DEBT ISSUANCE ($ billion)Base -24 70 87 92 97 100 107 115 123 126 132 1,047 445 Core Regulatory Change -24 9 77 96 144 193 248 294 335 360 393 2,150 519 Favorable Capital Markets -24 15 106 128 169 208 247 286 325 358 395 2,237 626 Accelerated Adjustment -24 -10 50 59 127 199 244 280 318 351 390 2,008 424

Differences over base scenario Core Regulatory Change 0 -61 -10 4 47 93 141 180 212 235 262 1,103 73 Favorable Capital Markets 0 -54 18 36 72 108 140 171 203 232 264 1,190 180 Accelerated Adjustment 0 -80 -38 -33 30 99 137 165 196 226 258 960 -21

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SHADOW CORE EQUITY PRICEBase 30.8% 10.0% 10.5% 8.8% 9.0% 8.7% 9.2% 8.8% 8.7% 8.9% 9.0% 9.2% 9.4% Core Regulatory Change 30.8% 10.0% 18.9% 10.8% 14.1% 2.7% 5.5% 6.4% 7.8% 9.9% 9.2% 9.5% 11.3% Favorable Capital Markets 13.5% 9.0% 10.8% 9.3% 10.0% 7.4% 7.7% 7.9% 8.2% 8.9% 8.9% 8.8% 9.3% Accelerated Adjustment 30.8% 27.6% 7.3% 7.4% 5.4% 6.5% 6.8% 7.1% 6.8% 9.7% 9.2% 9.4% 10.8%

Differences over base scenario (basis points) Core Regulatory Change 0 -5 843 204 512 -601 -374 -238 -91 95 12 36 191 Favorable Capital Markets -1,731 -99 35 55 103 -130 -149 -88 -57 -6 -14 -35 -7 Accelerated Adjustment 0 1,756 -317 -139 -351 -226 -242 -169 -192 75 20 22 145

LENDING RATE TO PRIVATE SECTORBase 4.5% 4.2% 4.4% 4.5% 5.0% 5.1% 5.4% 5.6% 5.7% 5.9% 6.1% 5.2% 4.6% Core Regulatory Change 4.5% 4.4% 6.0% 6.8% 8.2% 6.8% 6.5% 5.7% 6.5% 7.2% 7.7% 6.6% 6.4% Favorable Capital Markets 4.5% 4.2% 4.8% 5.3% 6.5% 6.6% 6.8% 6.8% 7.0% 7.3% 7.6% 6.3% 5.5% Accelerated Adjustment 4.5% 6.7% 7.1% 7.6% 5.6% 5.8% 6.0% 6.4% 6.6% 7.1% 7.6% 6.7% 6.6%

Differences over base scenario (basis points) Core Regulatory Change 0 26 160 229 324 169 109 14 78 134 166 141 182 Favorable Capital Markets 0 1 38 83 151 152 143 117 125 141 153 110 85 Accelerated Adjustment 0 258 272 307 60 70 61 84 92 129 154 149 193

NET INTEREST MARGINS (basis points)Base 348 316 311 303 309 293 304 306 299 296 296 308 306 Core Regulatory Change 348 292 365 396 455 351 327 272 294 315 328 340 372 Favorable Capital Markets 348 306 315 328 362 340 342 325 319 321 323 330 330 Accelerated Adjustment 348 432 432 444 313 300 302 309 301 313 323 347 384

Differences over base scenario Core Regulatory Change 0 -24 54 93 145 58 22 -34 -6 19 32 33 65 Favorable Capital Markets 0 -10 5 24 52 47 38 19 20 24 26 22 24 Accelerated Adjustment 0 116 121 141 4 6 -2 3 1 17 26 39 78

BANK RETURN ON EQUITYBase 6.4% 8.2% 8.0% 7.6% 8.2% 7.3% 8.1% 8.4% 8.0% 7.9% 8.0% 8.0% 7.8% Core Regulatory Change 6.4% 6.5% 10.3% 11.3% 13.5% 8.0% 6.9% 4.2% 5.6% 7.1% 8.1% 8.1% 9.9% Favorable Capital Markets 6.4% 7.3% 7.2% 7.4% 8.7% 7.5% 7.8% 7.2% 7.2% 7.5% 7.8% 7.5% 7.6% Accelerated Adjustment 6.4% 13.7% 12.1% 12.5% 5.9% 5.3% 5.6% 6.2% 6.0% 7.0% 7.7% 8.2% 9.9%

Differences over base scenario (percentage points) Core Regulatory Change 0.0% -1.7% 2.3% 3.7% 5.3% 0.7% -1.2% -4.2% -2.4% -0.7% 0.1% 0.2% 2.1% Favorable Capital Markets 0.0% -0.9% -0.8% -0.2% 0.5% 0.2% -0.3% -1.2% -0.8% -0.4% -0.2% -0.4% -0.2% Accelerated Adjustment 0.0% 5.5% 4.2% 4.8% -2.2% -1.9% -2.5% -2.2% -2.0% -0.9% -0.3% 0.2% 2.1%

CREDIT GROWTH TO PRIVATE SECTORBase 1.9% 2.9% 3.7% 3.7% 3.8% 3.7% 3.9% 4.0% 4.1% 4.0% 4.0% 3.8% 3.6% Core Regulatory Change 1.9% -0.3% -3.4% -2.5% -0.4% 1.4% 3.0% 5.2% 5.5% 5.2% 5.0% 1.9% -1.0% Favorable Capital Markets 1.9% 0.1% -1.9% -1.0% 0.5% 1.7% 2.5% 4.5% 4.9% 4.8% 4.8% 2.1% -0.1% Accelerated Adjustment 1.9% -1.3% -4.8% -4.3% -1.0% 2.0% 3.2% 5.1% 5.4% 5.3% 5.3% 1.5% -1.8%

Differences over base scenario (percentage points) Core Regulatory Change 0.0% -3.2% -7.0% -6.2% -4.2% -2.3% -0.9% 1.3% 1.5% 1.2% 1.0% -1.9% -4.6% Favorable Capital Markets 0.0% -2.8% -5.6% -4.7% -3.2% -2.1% -1.3% 0.6% 0.8% 0.8% 0.8% -1.7% -3.7% Accelerated Adjustment 0.0% -4.2% -8.4% -8.0% -4.7% -1.7% -0.6% 1.1% 1.3% 1.3% 1.3% -2.2% -5.4%

LIQUIDITY COVERAGE RATIO Base 86% 86% 87% 87% 87% 87% 88% 88% 88% 88% 89% Core Regulatory Change 86% 87% 96% 105% 118% 124% 130% 134% 137% 145% 154% Favorable Capital Markets 86% 86% 96% 104% 118% 124% 130% 133% 137% 145% 154% Accelerated Adjustment 86% 95% 102% 111% 119% 125% 131% 134% 138% 146% 155%

NET STABLE FUNDING RATIO Base 80% 81% 81% 81% 82% 82% 83% 83% 83% 84% 84% Core Regulatory Change 80% 81% 83% 86% 88% 91% 94% 96% 98% 100% 102% Favorable Capital Markets 80% 81% 83% 86% 88% 91% 94% 96% 98% 100% 102% Accelerated Adjustment 80% 81% 83% 86% 89% 91% 94% 96% 98% 100% 102%

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REAL GDP GROWTH (Y/Y)Base 2.6% 2.3% 3.0% 2.9% 2.8% 2.6% 2.6% 2.6% 2.6% 2.5% 2.5% 2.6% 2.7% Core Regulatory Change 2.6% 0.4% 0.9% 2.8% 3.3% 3.3% 3.6% 3.4% 2.9% 2.3% 2.2% 2.5% 2.2% Favorable Capital Markets 2.6% 0.6% 1.9% 3.1% 3.2% 3.0% 3.0% 3.0% 2.8% 2.5% 2.4% 2.6% 2.4% Accelerated Adjustment 2.6% -0.1% 0.6% 2.3% 3.9% 4.1% 3.5% 3.0% 2.7% 2.4% 2.3% 2.5% 2.2%

Differences over base scenario (percentage points) Core Regulatory Change 0.0% -1.9% -2.1% -0.1% 0.6% 0.7% 1.0% 0.8% 0.4% -0.2% -0.3% -0.1% -0.6% Favorable Capital Markets 0.0% -1.7% -1.1% 0.2% 0.5% 0.4% 0.4% 0.4% 0.2% 0.0% -0.1% -0.1% -0.4% Accelerated Adjustment 0.0% -2.4% -2.4% -0.6% 1.1% 1.5% 0.9% 0.4% 0.1% -0.1% -0.2% -0.2% -0.6%

REAL GDP (2010=100)Base 100.0 102.3 105.4 108.5 111.5 114.4 117.3 120.4 123.5 126.6 129.7 Core Regulatory Change 100.0 100.4 101.4 104.2 107.7 111.3 115.3 119.2 122.7 125.6 128.4 Favorable Capital Markets 100.0 100.6 102.5 105.6 109.0 112.3 115.8 119.2 122.6 125.7 128.7 Accelerated Adjustment 100.0 99.9 100.5 102.8 106.8 111.2 115.2 118.7 121.9 124.9 127.7

Differences over base scenario (percent) Core Regulatory Change 0.0% -1.8% -3.8% -3.9% -3.4% -2.7% -1.8% -1.0% -0.6% -0.8% -1.1% -1.9% -3.1% Favorable Capital Markets 0.0% -1.7% -2.8% -2.6% -2.2% -1.8% -1.3% -1.0% -0.7% -0.7% -0.8% -1.4% -2.2% Accelerated Adjustment 0.0% -2.4% -4.7% -5.2% -4.2% -2.7% -1.8% -1.4% -1.3% -1.4% -1.5% -2.4% -3.8%

EMPLOYMENT GROWTH (Y/Y)Base -1.7% 0.7% 1.1% 1.4% 1.2% 1.0% 0.9% 0.9% 0.9% 0.8% 0.8% 1.0% 1.1% Core Regulatory Change -1.7% -0.6% -1.3% 0.2% 1.5% 1.8% 2.0% 2.0% 1.6% 0.9% 0.5% 0.9% 0.3% Favorable Capital Markets -1.7% -0.5% -0.6% 0.9% 1.6% 1.5% 1.4% 1.4% 1.3% 1.0% 0.8% 0.9% 0.6% Accelerated Adjustment -1.7% -1.0% -1.8% -0.3% 1.7% 2.6% 2.3% 1.7% 1.2% 0.9% 0.6% 0.8% 0.2%

Differences over base scenario (percentage points) Core Regulatory Change 0.0% -1.3% -2.4% -1.1% 0.3% 0.8% 1.1% 1.1% 0.7% 0.1% -0.3% -0.1% -0.7% Favorable Capital Markets 0.0% -1.2% -1.7% -0.5% 0.4% 0.5% 0.5% 0.5% 0.4% 0.1% 0.0% -0.1% -0.5% Accelerated Adjustment 0.0% -1.7% -2.9% -1.6% 0.5% 1.6% 1.4% 0.8% 0.3% 0.0% -0.2% -0.2% -0.8%

EMPLOYMENT (million)Base 139.4 140.4 141.9 143.9 145.6 147.0 148.3 149.7 151.1 152.3 153.6 Core Regulatory Change 139.4 141.0 139.2 139.5 141.6 144.1 147.0 149.9 152.3 153.6 154.5 Favorable Capital Markets 139.4 141.0 140.2 141.5 143.7 145.9 148.0 150.1 152.0 153.5 154.7 Accelerated Adjustment 139.4 141.0 138.4 138.1 140.4 144.1 147.5 150.0 151.8 153.1 154.1

Differences over base scenario (thousand) Core Regulatory Change 0 596 -2,778 -4,377 -3,964 -2,886 -1,366 203 1,186 1,299 886 Favorable Capital Markets 0 596 -1,737 -2,395 -1,858 -1,108 -338 380 910 1,135 1,109 Accelerated Adjustment 0 596 -3,526 -5,803 -5,169 -2,908 -864 288 771 787 526

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IIF MACRO BANKING DATABASE: EURO AREA SCENARIOS COMPARED Avg or Avg or total total 2010e 2011p 2012p 2013p 2014p 2015p 2016p 2017p 2018p 2019p 2020p 11-20 11-15

EFFECTIVE REGULATORY CAPITAL RATIOBase 15.1% 15.1% 15.0% 14.9% 14.8% 14.7% 14.6% 14.5% 14.4% 14.3% 14.2% 14.6% 14.9% Core Regulatory Change 15.1% 15.1% 16.5% 16.9% 18.3% 18.2% 18.1% 18.0% 17.9% 17.8% 17.8% 17.5% 17.0% Accelerated Adjustment 15.1% 19.1% 19.0% 18.9% 18.3% 18.2% 18.1% 18.0% 17.9% 17.8% 17.8% 18.3% 18.7%


COMMON EQUITY RATIO Base 9.4% 9.5% 9.5% 9.5% 9.5% 9.5% 9.5% 9.5% 9.5% 9.5% 9.5% 9.5% 9.5% Core Regulatory Change 9.4% 9.5% 11.0% 11.5% 13.1% 13.1% 13.1% 13.1% 13.1% 13.1% 13.1% 12.4% 11.6% Accelerated Adjustment 9.4% 13.5% 13.5% 13.5% 13.1% 13.1% 13.1% 13.1% 13.1% 13.1% 13.1% 13.2% 13.3%


COMMON EQUITY (€ billion)Base 1,265 1,322 1,365 1,412 1,462 1,514 1,569 1,628 1,690 1,757 1,828 Core Regulatory Change 1,265 1,315 1,504 1,810 2,023 1,993 1,981 1,982 2,000 2,042 2,094 Favorable Capital Markets 1,265 1,320 1,520 1,850 2,093 2,081 2,073 2,071 2,083 2,127 2,184 Accelerated Adjustment 1,265 1,852 1,823 2,096 2,005 1,996 1,992 1,991 2,000 2,039 2,091

Differences over base scenario Core Regulatory Change 0 -7 139 398 561 480 412 355 309 285 266 Favorable Capital Markets 0 -2 155 438 631 567 504 443 393 370 356 Accelerated Adjustment 0 529 458 684 542 482 423 363 309 282 263

COMMON EQUITY GENERATION REQUIRED FROM PRIVATE SECTOR (€ billion, new issuance and retained profits)Base 38 67 53 57 60 62 65 69 63 66 71 633 299 Core Regulatory Change 38 60 200 316 270 27 45 59 64 42 53 1,135 873 Favorable Capital Markets 38 65 210 340 300 45 50 54 60 43 58 1,225 960 Accelerated Adjustment 38 597 -18 283 -34 48 53 56 56 39 53 1,132 875

Differences over base scenario Core Regulatory Change 0 -7 146 259 210 -34 -21 -10 2 -24 -19 502 574 Favorable Capital Markets 0 -2 157 283 240 -17 -16 -14 -3 -23 -14 592 661 Accelerated Adjustment 0 529 -71 226 -95 -13 -12 -12 -6 -27 -19 499 576

LONG-TERM DEBT ISSUANCE (€ billion)Base -36 605 177 192 207 212 227 242 258 274 295 2,689 1,393 Core Regulatory Change -36 578 301 -49 95 293 284 280 432 657 634 3,506 1,218 Favorable Capital Markets -36 598 333 6 160 353 314 283 436 684 673 3,839 1,450 Accelerated Adjustment -36 -16 494 -27 426 345 309 275 409 647 634 3,495 1,221

Differences over base scenario Core Regulatory Change 0 -27 125 -241 -112 81 57 38 174 383 340 818 -175 Favorable Capital Markets 0 -7 156 -186 -47 141 87 41 178 409 378 1,150 57 Accelerated Adjustment 0 -621 317 -219 219 132 82 33 151 373 340 806 -172

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SHADOW CORE EQUITY PRICEBase 8.2% 5.1% 11.7% 11.1% 9.7% 8.1% 7.6% 7.1% 6.4% 6.2% 6.1% 7.9% 9.1% Core Regulatory Change 8.2% 5.1% 17.7% 19.7% 11.6% 2.5% 3.8% 5.2% 5.7% 5.5% 5.4% 8.2% 11.3% Favorable Capital Markets 7.1% 6.6% 8.9% 9.3% 8.0% 5.9% 5.8% 5.7% 5.7% 5.8% 5.8% 6.8% 7.7% Accelerated Adjustment 8.2% 28.0% 3.5% 14.1% 2.0% 6.8% 5.4% 5.8% 4.6% 5.3% 5.5% 8.1% 10.9%

Differences over base scenario (basis points) Core Regulatory Change 0 -2 605 859 191 -562 -384 -189 -75 -67 -68 31 218 Favorable Capital Markets -111 144 -274 -178 -172 -216 -177 -140 -72 -41 -28 -115 -139 Accelerated Adjustment 0 2290 -816 303 -771 -123 -219 -132 -184 -86 -56 21 177

LENDING RATE TO PRIVATE SECTORBase 3.4% 3.5% 4.2% 5.2% 6.2% 6.7% 7.0% 7.3% 7.5% 7.6% 7.8% 6.3% 5.2% Core Regulatory Change 3.4% 3.5% 5.1% 7.6% 9.7% 9.7% 9.3% 9.5% 10.6% 11.4% 12.0% 8.8% 7.1% Favorable Capital Markets 3.4% 3.5% 4.3% 5.6% 7.0% 7.9% 8.6% 9.1% 9.7% 10.2% 10.6% 7.6% 5.7% Accelerated Adjustment 3.4% 5.5% 5.9% 7.8% 7.0% 8.6% 8.9% 10.2% 10.7% 11.3% 11.8% 8.8% 7.0%

Differences over base scenario (basis points) Core Regulatory Change 0 3 91 240 344 298 224 222 309 376 419 253 195 Favorable Capital Markets 0 4 8 38 79 123 153 183 222 254 276 134 50 Accelerated Adjustment 0 197 167 267 77 195 186 290 319 366 405 247 181

NET INTEREST MARGINS (basis points)Base 198 47 56 77 102 108 113 119 122 123 124 99 78 Core Regulatory Change 198 54 68 140 193 168 135 129 151 160 167 136 125 Favorable Capital Markets 198 67 54 83 118 135 147 156 165 170 176 127 91 Accelerated Adjustment 198 152 114 163 89 128 121 155 155 157 162 140 129

Differences over base scenario Core Regulatory Change 0 7 13 63 91 60 21 10 29 38 43 37 47 Favorable Capital Markets 0 19 -1 6 16 27 34 37 43 47 52 28 13 Accelerated Adjustment 0 104 58 86 -13 20 7 36 34 35 38 41 51

BANK RETURN ON EQUITYBase 13.9% -1.1% -0.1% 2.6% 5.9% 6.8% 7.6% 8.4% 8.9% 9.1% 9.5% 5.8% 2.8% Core Regulatory Change 13.9% -0.3% 1.3% 8.2% 11.9% 9.4% 6.5% 5.7% 7.3% 8.0% 8.5% 6.7% 6.1% Favorable Capital Markets 13.9% 1.0% -0.3% 2.6% 5.5% 6.6% 7.4% 7.9% 8.5% 8.8% 9.3% 5.7% 3.1% Accelerated Adjustment 13.9% 9.5% 5.6% 9.4% 3.2% 6.1% 5.3% 7.9% 7.7% 7.7% 8.1% 7.1% 6.8%

Differences over base scenario (percentage points) Core Regulatory Change 0.0% 0.8% 1.4% 5.6% 6.1% 2.6% -1.2% -2.7% -1.6% -1.1% -1.0% 0.9% 3.3% Favorable Capital Markets 0.0% 2.1% -0.2% 0.0% -0.4% -0.2% -0.3% -0.5% -0.4% -0.3% -0.1% 0.0% 0.2% Accelerated Adjustment 0.0% 10.6% 5.7% 6.8% -2.7% -0.7% -2.3% -0.6% -1.2% -1.4% -1.4% 1.3% 3.9%

CREDIT GROWTH TO PRIVATE SECTORBase 1.8% 2.9% 3.3% 3.4% 3.6% 3.5% 3.6% 3.7% 3.8% 3.9% 4.1% 3.6% 3.3% Core Regulatory Change 1.8% 2.3% -2.5% -3.1% -3.2% -3.0% -2.1% -1.5% 0.5% 3.2% 3.3% -0.6% -1.9% Favorable Capital Markets 1.8% 2.7% -1.9% -2.0% -2.0% -2.1% -1.9% -1.7% 0.3% 3.2% 3.4% -0.2% -1.0% Accelerated Adjustment 1.8% 1.4% -2.9% -3.2% -2.8% -1.9% -1.7% -1.6% 0.1% 3.1% 3.3% -0.6% -1.9%

Differences over base scenario (percentage points) Core Regulatory Change 0.0% -0.6% -5.8% -6.5% -6.8% -6.5% -5.8% -5.2% -3.3% -0.7% -0.8% -4.2% -5.2% Favorable Capital Markets 0.0% -0.1% -5.2% -5.4% -5.5% -5.6% -5.5% -5.4% -3.6% -0.7% -0.6% -3.8% -4.4% Accelerated Adjustment 0.0% -1.5% -6.1% -6.6% -6.3% -5.5% -5.4% -5.3% -3.7% -0.9% -0.8% -4.2% -5.2%

LIQUIDITY COVERAGE RATIOBase 69% 69% 69% 69% 69% 69% 69% 69% 69% 69% 69% Core Regulatory Change 69% 69% 73% 77% 82% 87% 92% 97% 102% 109% 115% Favorable Capital Markets 69% 69% 73% 77% 82% 87% 92% 97% 103% 109% 115% Accelerated Adjustment 69% 69% 73% 78% 82% 87% 92% 97% 102% 109% 115%

NET STABLE FUNDING RATIOBase 73% 75% 76% 76% 72% 72% 72% 72% 72% 73% 73% Core Regulatory Change 73% 75% 79% 81% 79% 82% 85% 88% 91% 94% 96% Favorable Capital Markets 73% 75% 79% 80% 79% 82% 85% 88% 91% 94% 96% Accelerated Adjustment 73% 73% 77% 79% 79% 82% 85% 88% 91% 94% 96%

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REAL GDP GROWTH (Y/Y)Base 1.7% 1.5% 1.8% 1.8% 1.8% 1.7% 1.7% 1.6% 1.7% 1.7% 1.8% 1.7% 1.7% Core Regulatory Change 1.7% 1.1% 1.3% 1.1% 1.0% 1.1% 1.5% 1.7% 1.5% 1.3% 1.4% 1.3% 1.1% Favorable Capital Markets 1.7% 1.3% 1.6% 1.6% 1.5% 1.3% 1.3% 1.3% 1.4% 1.4% 1.5% 1.4% 1.4% Accelerated Adjustment 1.7% 0.8% 0.9% 1.2% 1.5% 1.8% 1.4% 1.3% 1.2% 1.4% 1.5% 1.3% 1.2%

Differences over base scenario (percentage points) Core Regulatory Change 0.0% -0.4% -0.5% -0.8% -0.8% -0.6% -0.1% 0.1% -0.1% -0.4% -0.4% -0.4% -0.6% Favorable Capital Markets 0.0% -0.2% -0.2% -0.2% -0.4% -0.5% -0.4% -0.3% -0.3% -0.3% -0.2% -0.3% -0.3% Accelerated Adjustment 0.0% -0.7% -0.9% -0.7% -0.3% 0.0% -0.3% -0.4% -0.5% -0.3% -0.2% -0.4% -0.5%

REAL GDP (2010=100) Base 100.0 101.5 103.3 105.2 107.1 109.0 110.8 112.6 114.5 116.5 118.5 Core Regulatory Change 100.0 101.1 102.4 103.5 104.6 105.8 107.4 109.2 110.9 112.4 113.9 Favorable Capital Markets 100.0 101.3 102.9 104.6 106.1 107.4 108.8 110.3 111.8 113.3 115.1 Accelerated Adjustment 100.0 100.8 101.7 102.9 104.5 106.3 107.8 109.1 110.4 111.9 113.6


EMPLOYMENT GROWTH (Y/Y) Base -0.8% 0.5% 0.5% 0.6% 0.6% 0.6% 0.5% 0.5% 0.5% 0.5% 0.6% 0.6% 0.6% Core Regulatory Change -0.8% 0.3% 0.2% 0.2% 0.1% 0.1% 0.3% 0.5% 0.5% 0.4% 0.3% 0.3% 0.2% Favorable Capital Markets -0.8% 0.4% 0.3% 0.5% 0.4% 0.3% 0.2% 0.3% 0.3% 0.3% 0.4% 0.3% 0.4% Accelerated Adjustment -0.8% 0.2% -0.1% 0.1% 0.3% 0.5% 0.5% 0.3% 0.2% 0.2% 0.4% 0.3% 0.2%

Differences over base scenario (percentage points) Core Regulatory Change 0.0% -0.1% -0.3% -0.4% -0.6% -0.5% -0.3% 0.0% 0.0% -0.2% -0.3% -0.3% -0.4% Favorable Capital Markets 0.0% -0.1% -0.1% -0.2% -0.2% -0.3% -0.3% -0.3% -0.2% -0.2% -0.2% -0.2% -0.2% Accelerated Adjustment 0.0% -0.2% -0.6% -0.6% -0.4% -0.1% -0.1% -0.2% -0.3% -0.3% -0.2% -0.3% -0.4%

EMPLOYMENT (million) Base 141.4 142.0 142.7 143.6 144.5 145.4 146.2 147.0 147.7 148.5 149.3 Core Regulatory Change 141.4 141.8 142.1 142.3 142.5 142.6 143.0 143.7 144.4 144.9 145.3 Favorable Capital Markets 141.4 141.9 142.4 143.1 143.7 144.2 144.5 144.9 145.3 145.8 146.3 Accelerated Adjustment 141.4 141.7 141.6 141.6 142.1 142.8 143.4 143.8 144.1 144.5 145.0

Differences over base scenario (thousand) Core Regulatory Change 0 -188 -638 -1,269 -2,089 -2,825 -3,217 -3,275 -3,316 -3,587 -4,012 Favorable Capital Markets 0 -82 -284 -510 -808 -1,240 -1,695 -2,083 -2,419 -2,742 -3,034 Accelerated Adjustment 0 -335 -1,153 -1,960 -2,471 -2,630 -2,751 -3,103 -3,564 -4,020 -4,356

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IIF MACRO BANKING DATABASE: JAPAN SCENARIOS COMPARED Avg or Avg or total total 2010e 2011p 2012p 2013p 2014p 2015p 2016p 2017p 2018p 2019p 2020p 11-20 11-15

EFFECTIVE REGULATORY CAPITAL RATIO Base 13.0% 12.5% 12.1% 11.9% 11.9% 11.9% 11.9% 11.9% 11.9% 11.9% 11.9% 12.0% 12.1% Core Regulatory Change 13.0% 12.5% 13.6% 13.9% 16.1% 16.1% 16.1% 16.1% 16.1% 16.1% 16.1% 15.3% 14.4% Accelerated Adjustment 13.0% 15.5% 15.6% 15.9% 16.1% 16.1% 16.1% 16.1% 16.1% 16.1% 16.1% 16.0% 15.8%




COMMON EQUITY (¥ trillion) Base 20 20 20 20 21 22 22 23 24 24 25 Core Regulatory Change 20 20 24 26 35 35 36 37 38 38 39 Favorable Capital Markets 20 20 25 27 36 36 37 38 39 40 40 Accelerated Adjustment 20 31 32 34 35 36 36 37 38 38 39

Difference over base scenario Core Regulatory Change 0 -1 4 6 14 14 14 14 14 14 14 Favorable Capital Markets 0 0 5 7 15 15 15 15 15 15 15 Accelerated Adjustment 0 11 12 14 14 14 14 14 14 14 14

COMMON EQUITY GENERATION REQUIRED FROM PRIVATE SECTOR (¥ trillion, new issuance and retained profits) Base 1.0 0.2 -0.4 0.1 0.7 0.7 0.7 0.7 0.6 0.5 0.4 4.3 1.3 Core Regulatory Change 1.0 -0.3 4.5 1.9 10.9 2.7 3.2 3.4 3.2 0.5 0.4 30.4 19.6 Favorable Capital Markets 1.0 -0.2 4.7 2.1 11.5 3.0 3.3 3.3 3.1 0.6 0.4 31.8 21.1 Accelerated Adjustment 1.0 10.8 0.6 2.1 4.0 2.9 3.1 3.0 3.0 0.6 0.5 30.5 20.3

Difference over base scenario Core Regulatory Change 0.0 -0.6 5.0 1.8 10.2 1.9 2.5 2.7 2.5 0.0 0.0 26.1 18.3 Favorable Capital Markets 0.0 -0.5 5.2 2.0 10.8 2.2 2.6 2.6 2.5 0.0 0.0 27.5 19.7 Accelerated Adjustment 0.0 10.5 1.0 1.9 3.3 2.1 2.4 2.3 2.4 0.1 0.1 26.2 19.0

LONG-TERM DEBT ISSUANCE (¥ trillion) Base -0.3 0.5 0.5 0.3 0.2 0.2 0.2 0.2 0.2 0.1 0.1 2.5 1.7 Core Regulatory Change -0.3 0.9 1.0 3.0 1.0 5.0 10.0 10.0 10.0 10.0 5.0 55.9 10.9 Favorable Capital Markets -0.3 0.9 1.0 3.0 1.0 5.0 10.0 10.0 10.0 10.0 5.0 55.9 10.9 Accelerated Adjustment -0.3 0.9 1.0 3.0 1.0 5.0 10.0 10.0 10.0 10.0 5.0 55.9 10.9

Difference over base scenario Core Regulatory Change 0.0 0.4 0.5 2.7 0.8 4.8 9.8 9.8 9.8 9.9 4.9 53.4 9.2 Favorable Capital Markets 0.0 0.4 0.5 2.7 0.8 4.8 9.8 9.8 9.8 9.9 4.9 53.4 9.2 Accelerated Adjustment 0.0 0.4 0.5 2.7 0.8 4.8 9.8 9.8 9.8 9.9 4.9 53.4 9.2

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SHADOW CORE EQUITY PRICEBase 6.3% 5.3% 2.8% 4.8% 6.0% 5.8% 5.1% 4.7% 4.6% 4.6% 4.4% 4.8% 4.9% Core Regulatory Change 6.3% 5.3% 16.2% 6.5% 25.1% 1.7% 4.7% 4.6% 7.7% 2.9% 3.1% 7.8% 11.0% Favorable Capital Markets 4.9% 4.6% 6.8% 4.9% 8.7% 4.0% 4.2% 4.1% 4.2% 3.5% 3.5% 4.9% 5.8% Accelerated Adjustment 6.3% 33.3% -0.1% 3.4% 5.7% 8.1% 7.1% 6.2% 5.9% 2.6% 3.2% 7.5% 10.1%

Differences over base scenario (basis points) Core Regulatory Change 0 0 1,347 164 1,902 -408 -40 -13 305 -161 -133 296 601 Favorable Capital Markets -140 -73 402 12 261 -178 -89 -54 -38 -104 -88 5 85 Accelerated Adjustment 0 2,801 -284 -140 -33 226 204 151 127 -199 -123 273 514

LENDING RATE TO PRIVATE SECTOR Base 1.5% 1.5% 1.2% 1.1% 1.2% 1.5% 1.6% 1.6% 1.7% 1.7% 1.8% 1.5% 1.3% Core Regulatory Change 1.5% 1.5% 2.0% 2.2% 3.8% 3.3% 3.5% 2.5% 3.2% 3.5% 3.7% 2.9% 2.6% Favorable Capital Markets 1.5% 1.5% 1.5% 1.6% 2.1% 2.3% 2.6% 2.6% 2.9% 3.1% 3.4% 2.4% 1.8% Accelerated Adjustment 1.5% 3.2% 2.8% 2.8% 1.6% 2.3% 2.9% 3.2% 3.4% 3.4% 3.5% 2.9% 2.5%

Differences over base scenario (basis points) Core Regulatory Change 0 2 80 104 252 183 195 91 157 172 186 142 124 Favorable Capital Markets 0 -1 28 43 89 81 97 93 121 141 159 85 48 Accelerated Adjustment 0 166 160 170 31 85 127 157 172 168 172 141 122

NET INTEREST MARGINS (basis points) Base 114 123 103 100 104 117 124 126 127 129 133 119 109 Core Regulatory Change 114 123 156 168 269 232 242 168 205 210 217 199 190 Favorable Capital Markets 114 121 121 128 162 168 181 174 187 196 206 165 140 Accelerated Adjustment 114 235 210 212 123 170 198 212 215 208 209 199 190

Differences over base scenario Core Regulatory Change 0 1 53 68 164 115 117 43 79 81 85 81 80 Favorable Capital Markets 0 -1 18 28 58 51 57 48 60 67 74 46 31 Accelerated Adjustment 0 112 107 113 19 52 74 86 88 78 76 81 81

BANK RETURN ON EQUITY Base 3.2% 4.3% 2.3% 2.0% 2.4% 3.9% 4.7% 4.8% 5.0% 5.3% 5.7% 4.0% 3.0% Core Regulatory Change 3.2% 4.1% 6.6% 6.6% 13.9% 9.2% 9.4% 2.9% 5.3% 5.1% 5.0% 6.8% 8.1% Favorable Capital Markets 3.2% 3.9% 3.0% 2.7% 4.7% 4.1% 4.6% 3.4% 3.9% 4.0% 4.2% 3.9% 3.7% Accelerated Adjustment 3.2% 14.3% 10.2% 9.4% 1.2% 4.2% 5.9% 6.4% 6.1% 4.9% 4.3% 6.7% 7.9%

Differences over base scenario (percentage points) Core Regulatory Change 0.0% -0.2% 4.3% 4.6% 11.5% 5.4% 4.7% -1.9% 0.3% -0.2% -0.7% 2.8% 5.1% Favorable Capital Markets 0.0% -0.4% 0.7% 0.8% 2.3% 0.3% -0.1% -1.4% -1.1% -1.3% -1.5% -0.2% 0.7% Accelerated Adjustment 0.0% 9.9% 7.9% 7.5% -1.2% 0.3% 1.2% 1.6% 1.1% -0.4% -1.4% 2.7% 4.9%

CREDIT GROWTH TO PRIVATE SECTOR Base 2.0% 1.2% 1.8% 2.6% 3.3% 3.5% 3.4% 3.1% 2.7% 2.2% 1.8% 2.6% 2.5% Core Regulatory Change 2.0% -1.6% -4.9% -1.1% -3.3% 0.2% 2.1% 2.6% 1.8% 1.2% 0.9% -0.2% -2.1% Favorable Capital Markets 2.0% -1.2% -4.2% -0.3% -2.0% 1.0% 2.4% 2.1% 1.6% 1.2% 0.8% 0.1% -1.3% Accelerated Adjustment 2.0% -2.7% -4.8% -0.9% -1.2% 0.7% 1.7% 1.4% 1.3% 1.3% 1.1% -0.2% -1.8%

Differences over base scenario (percentage points) Core Regulatory Change 0.0% -2.8% -6.7% -3.7% -6.6% -3.3% -1.3% -0.5% -0.9% -1.1% -1.0% -2.8% -4.6% Favorable Capital Markets 0.0% -2.4% -5.9% -3.0% -5.3% -2.5% -1.0% -0.9% -1.0% -1.0% -1.0% -2.4% -3.8% Accelerated Adjustment 0.0% -3.9% -6.6% -3.5% -4.5% -2.8% -1.7% -1.7% -1.3% -0.9% -0.7% -2.8% -4.3%



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REAL GDP GROWTH (Y/Y) Base 4.0% 1.6% 1.4% 1.7% 1.9% 1.8% 1.6% 1.3% 1.0% 0.8% 0.6% 1.4% 1.7% Core Regulatory Change 4.0% -0.5% 0.4% 1.5% 1.1% 1.8% 1.8% 2.1% 1.0% 0.6% 0.5% 1.0% 0.9% Favorable Capital Markets 4.0% -0.3% 1.0% 1.9% 2.0% 2.1% 1.7% 1.4% 1.0% 0.7% 0.5% 1.2% 1.3% Accelerated Adjustment 4.0% -1.7% 0.9% 1.8% 3.1% 1.7% 1.1% 0.9% 0.9% 0.9% 0.8% 1.0% 1.2%

Differences over base scenario (percentage points) Core Regulatory Change 0.0% -2.2% -0.9% -0.2% -0.8% 0.0% 0.2% 0.7% 0.0% -0.2% -0.1% -0.3% -0.8% Favorable Capital Markets 0.0% -2.0% -0.3% 0.2% 0.1% 0.3% 0.1% 0.1% -0.1% -0.1% -0.1% -0.2% -0.3% Accelerated Adjustment 0.0% -3.3% -0.4% 0.1% 1.2% -0.1% -0.5% -0.4% -0.1% 0.1% 0.2% -0.3% -0.5%



EMPLOYMENT GROWTH (Y/Y) Base -0.1% -0.3% -0.4% -0.3% -0.3% -0.3% -0.3% -0.4% -0.4% -0.5% -0.5% -0.4% -0.3% Core Regulatory Change -0.1% -0.7% -0.6% -0.4% -0.4% -0.3% -0.3% -0.2% -0.4% -0.5% -0.5% -0.4% -0.5% Favorable Capital Markets -0.1% -0.7% -0.4% -0.3% -0.3% -0.2% -0.3% -0.4% -0.5% -0.5% -0.5% -0.4% -0.4% Accelerated Adjustment -0.1% -1.0% -0.5% -0.3% -0.1% -0.3% -0.4% -0.5% -0.5% -0.5% -0.5% -0.4% -0.4%

Differences over base scenario (percentage points) Core Regulatory Change 0.0% -0.4% -0.2% 0.0% -0.2% 0.0% 0.0% 0.1% 0.0% 0.0% 0.0% -0.1% -0.2% Favorable Capital Markets 0.0% -0.4% -0.1% 0.0% 0.0% 0.1% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% -0.1% Accelerated Adjustment 0.0% -0.6% -0.1% 0.0% 0.2% 0.0% -0.1% -0.1% 0.0% 0.0% 0.0% -0.1% -0.1%


Differences over base scenario (thousand) Core Regulatory Change 0 -257 -367 -394 -486 -485 -458 -370 -368 -393 -400 Favorable Capital Markets 0 -236 -275 -248 -233 -202 -189 -177 -183 -194 -200 Accelerated Adjustment 0 -392 -443 -431 -289 -305 -364 -411 -424 -405 -383

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IIF MACRO BANKING DATABASE: UNITED KINGDOM SCENARIOS COMPARED Avg or Avg or total total 2010e 2011p 2012p 2013p 2014p 2015p 2016p 2017p 2018p 2019p 2020p 11-20 11-15


Differences over base scenario (percentage points) Core Regulatory Change 0.0% -0.2% 1.0% 1.2% 3.2% 2.9% 2.6% 2.3% 2.0% 1.7% 1.4% 1.8% 1.6% Accelerated Adjustment 0.0% 2.8% 3.0% 3.2% 3.2% 2.9% 2.6% 2.3% 2.0% 1.7% 1.4% 2.5% 3.0%



COMMON EQUITY (£ billion) Base 291 282 276 270 276 290 304 319 335 351 369 Core Regulatory Change 291 278 317 353 426 428 398 386 388 406 437 Favorable Capital Markets 291 281 325 371 462 478 484 503 529 557 585 Accelerated Adjustment 291 380 377 413 406 418 401 400 407 425 451

Differences over base scenario Core Regulatory Change 0 -4 41 84 150 138 94 67 54 55 67 Favorable Capital Markets 0 -1 50 102 186 189 180 185 194 205 215 Accelerated Adjustment 0 97 101 144 130 128 97 81 72 73 82

COMMON EQUITY GENERATION REQUIRED FROM PRIVATE SECTOR (£ billion, new issuance and retained profits)Base 27 -9 -6 16 29 34 14 15 16 17 18 143 64 Core Regulatory Change 27 -13 38 59 109 37 -15 3 17 18 30 283 230 Favorable Capital Markets 27 -10 44 68 128 52 20 34 40 28 28 431 281 Accelerated Adjustment 27 89 -3 59 30 47 -2 14 21 17 26 297 221

Differences over base scenario Core Regulatory Change 0 -4 45 43 81 2 -29 -12 1 1 12 139 167 Favorable Capital Markets 0 -1 50 52 99 17 6 19 24 11 10 287 218 Accelerated Adjustment 0 97 4 43 1 12 -17 -1 6 1 8 154 157

LONG-TERM DEBT ISSUANCE (£ billion) Base -1 17 17 19 21 22 23 25 26 28 29 228 97 Core Regulatory Change -1 12 29 29 24 25 5 -8 9 30 46 201 119 Favorable Capital Markets -1 16 35 39 41 43 50 32 40 44 45 386 174 Accelerated Adjustment -1 8 21 21 22 35 19 6 16 29 41 219 108

Differences over base scenario Core Regulatory Change 0 -6 12 10 3 3 -18 -33 -17 2 17 -27 22 Favorable Capital Markets 0 -1 18 20 20 21 27 7 14 17 16 158 77 Accelerated Adjustment 0 -9 4 2 1 13 -4 -19 -10 2 12 -9 11

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SHADOW CORE EQUITY PRICE Base 24.7% 16.5% 11.7% 14.3% 17.7% 19.1% 14.3% 11.5% 10.4% 10.5% 10.8% 13.7% 15.9% Core Regulatory Change 25.6% 17.1% 24.3% 29.8% 36.0% 25.1% 15.3% 11.6% 10.6% 10.7% 10.9% 19.1% 26.5% Favorable Capital Markets 14.8% 10.2% 15.1% 17.3% 19.9% 13.2% 9.5% 9.0% 9.1% 9.2% 9.2% 12.2% 15.1% Accelerated Adjustment 25.6% 39.9% 25.3% 27.4% 20.3% 18.2% 12.7% 11.3% 10.9% 10.9% 11.0% 18.8% 26.2%

Differences over base scenario (basis points) Core Regulatory Change 81 57 1,252 1,552 1,829 597 100 4 17 18 11 544 1,058 Favorable Capital Markets -997 -631 333 300 217 -591 -483 -251 -133 -132 -160 -153 -74 Accelerated Adjustment 81 2,340 1,360 1,308 257 -98 -158 -20 47 44 23 510 1,033


Differences over base scenario (basis points) Core Regulatory Change 0 11 151 353 629 632 484 220 88 36 12 262 355 Favorable Capital Markets 0 -58 -14 47 189 134 51 -44 -40 -31 -39 19 60 Accelerated Adjustment 0 296 478 693 492 365 173 98 57 41 21 271 465


Differences over base scenario Core Regulatory Change 0 -6 43 116 214 210 151 55 11 -6 -12 78 115 Favorable Capital Markets 0 -24 -12 8 58 34 0 -35 -31 -27 -29 -6 13 Accelerated Adjustment 0 101 166 242 163 112 36 10 -1 -4 -9 82 157

BANK RETURN ON EQUITY Base 0.6% 3.3% 3.6% 4.5% 6.2% 8.6% 9.4% 8.8% 7.5% 7.0% 7.0% 6.6% 5.3% Core Regulatory Change -0.1% 1.7% 3.0% 4.8% 7.0% 7.5% 6.8% 5.1% 3.9% 3.6% 3.5% 4.7% 4.8% Favorable Capital Markets -0.1% 1.3% 1.7% 2.5% 3.9% 4.2% 4.0% 3.3% 3.0% 3.1% 3.1% 3.0% 2.7% Accelerated Adjustment -0.1% 3.9% 5.1% 6.7% 5.6% 5.7% 4.7% 4.2% 3.7% 3.6% 3.6% 4.7% 5.4%

Differences over base scenario (percentage points) Core Regulatory Change -0.7% -1.6% -0.6% 0.3% 0.8% -1.1% -2.5% -3.7% -3.6% -3.4% -3.5% -1.9% -0.4% Favorable Capital Markets -0.7% -2.0% -1.9% -2.1% -2.3% -4.4% -5.3% -5.5% -4.5% -3.9% -3.9% -3.6% -2.5% Accelerated Adjustment -0.7% 0.6% 1.5% 2.2% -0.5% -2.9% -4.6% -4.6% -3.8% -3.4% -3.4% -1.9% 0.1%

CREDIT GROWTH TO PRIVATE SECTOR Base 10.5% 4.5% 4.3% 4.7% 4.9% 4.9% 4.9% 5.0% 5.0% 5.0% 5.1% 4.8% 4.7% Core Regulatory Change 10.5% 3.1% -1.0% -1.3% -2.8% -2.9% -7.2% -1.6% 1.9% 5.9% 8.7% 0.3% -1.0% Favorable Capital Markets 10.5% 4.2% 0.6% 0.8% 0.4% 0.1% 0.8% 5.3% 6.3% 6.5% 6.3% 3.2% 1.3% Accelerated Adjustment 10.5% 2.2% -2.8% -3.0% -3.1% -0.5% -4.3% 1.1% 3.0% 5.5% 7.4% 0.6% -1.5%

Differences over base scenario (percentage points) Core Regulatory Change 0.0% -1.5% -5.2% -6.0% -7.7% -7.8% -12% -6.6% -3.1% 0.9% 3.6% -4.6% -5.6% Favorable Capital Markets 0.0% -0.3% -3.6% -3.9% -4.5% -4.8% -4.0% 0.4% 1.3% 1.5% 1.2% -1.7% -3.4% Accelerated Adjustment 0.0% -2.3% -7.1% -7.7% -8.0% -5.4% -9.2% -3.9% -1.9% 0.5% 2.3% -4.3% -6.1%



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REAL GDP GROWTH (Y/Y) Base 1.7% 2.0% 2.3% 2.4% 2.5% 2.6% 2.6% 2.6% 2.7% 2.7% 2.7% 2.5% 2.4% Core Regulatory Change 1.7% 0.8% 1.2% 1.4% 0.8% 2.0% -2.1% 3.5% 6.5% 6.1% 4.9% 2.5% 1.2% Favorable Capital Markets 1.7% 1.8% 2.1% 2.2% 2.0% 2.3% 3.2% 3.7% 3.4% 2.7% 2.4% 2.6% 2.1% Accelerated Adjustment 1.7% 0.0% -0.1% 1.2% 2.3% 4.5% -1.5% 3.2% 5.2% 4.9% 4.4% 2.4% 1.6%

Differences over base scenario (percentage points) Core Regulatory Change 0.0% -1.2% -1.1% -1.1% -1.7% -0.6% -4.7% 0.9% 3.8% 3.4% 2.2% 0.0% -1.1% Favorable Capital Markets 0.0% -0.2% -0.2% -0.3% -0.5% -0.3% 0.6% 1.0% 0.7% 0.0% -0.4% 0.0% -0.3% Accelerated Adjustment 0.0% -2.0% -2.3% -1.2% -0.2% 1.9% -4.1% 0.5% 2.5% 2.2% 1.7% -0.1% -0.8%


Differences over base scenario (percent) Core Regulatory Change 0.0% -1.2% -2.2% -3.3% -4.9% -5.5% -9.8% -9.0% -5.7% -2.5% -0.5% -4.5% -3.4% Favorable Capital Markets 0.0% -0.2% -0.4% -0.6% -1.2% -1.5% -0.9% 0.0% 0.8% 0.8% 0.4% -0.3% -0.8% Accelerated Adjustment 0.0% -1.9% -4.2% -5.3% -5.5% -3.7% -7.6% -7.1% -4.8% -2.7% -1.2% -4.4% -4.1%

EMPLOYMENT GROWTH (Y/Y) Base 0.0% 0.0% 0.2% 0.4% 0.5% 0.6% 0.6% 0.6% 0.7% 0.7% 0.7% 0.5% 0.3% Core Regulatory Change 0.0% -0.3% -0.7% -0.4% -0.5% -0.5% -1.0% -1.5% 2.1% 3.5% 3.0% 0.4% -0.5% Favorable Capital Markets 0.0% -0.1% 0.1% 0.3% 0.2% 0.2% 0.6% 1.2% 1.4% 1.1% 0.6% 0.5% 0.1% Accelerated Adjustment 0.0% -0.5% -1.4% -1.1% -0.1% 1.0% 0.5% -1.3% 1.6% 2.5% 2.3% 0.3% -0.4%

Differences over base scenario (percentage points) Core Regulatory Change 0.0% -0.3% -0.9% -0.8% -1.0% -1.0% -1.6% -2.1% 1.4% 2.8% 2.3% -0.1% -0.8% Favorable Capital Markets 0.0% -0.1% -0.2% -0.2% -0.3% -0.4% 0.0% 0.6% 0.7% 0.4% -0.1% 0.1% -0.2% Accelerated Adjustment 0.0% -0.5% -1.6% -1.5% -0.7% 0.4% -0.1% -1.9% 0.9% 1.9% 1.6% -0.2% -0.8%


Differences over base scenario (thousand) Core Regulatory Change 0 -94 -358 -599 -888 -1188 -1635 -2247 -1864 -1080 -414 Favorable Capital Markets 0 -17 -60 -105 -190 -298 -303 -139 71 187 161 Accelerated Adjustment 0 -153 -624 -1054 -1244 -1135 -1175 -1736 -1483 -960 -504

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IIF MACRO BANKING DATABASE: SWITZERLAND SCENARIOS COMPARED Avg or Avg or total total 2010e 2011p 2012p 2013p 2014p 2015p 2016p 2017p 2018p 2019p 2020p 11-20 11-15





COMMON EQUITY (CHF billion) Base 105 106 107 108 109 110 110 111 112 113 114 Core Regulatory Change 105 106 123 146 153 155 158 162 166 171 175 Favorable Capital Markets 105 106 124 149 158 161 165 169 173 177 181 Accelerated Adjustment 105 131 131 149 149 152 155 159 163 167 172

Differences over base scenario Core Regulatory Change 0 0 16 38 44 46 48 50 54 58 61 Favorable Capital Markets 0 0 17 41 49 52 54 57 61 64 68 Accelerated Adjustment 0 25 24 42 40 42 44 47 51 54 58

COMMON EQUITY GENERATION REQUIRED FROM PRIVATE SECTOR (CHF billion, new issuance and retained profits) Base 7 1 1 1 1 1 1 1 1 1 1 8 1 Core Regulatory Change 7 1 17 23 13 8 9 9 10 4 4 99 12 Favorable Capital Markets 7 1 17 25 15 9 9 10 10 4 4 105 14 Accelerated Adjustment 7 26 0 19 6 8 9 10 10 4 4 95 12

Differences over base scenario Core Regulatory Change 0 0 16 22 12 7 8 8 9 4 4 90 11 Favorable Capital Markets 0 0 17 24 14 8 9 9 9 3 3 97 13 Accelerated Adjustment 0 25 -1 18 5 7 8 9 9 4 4 87 11

LONG-TERM DEBT ISSUANCE (CHF billion; includes CoCos) Base 8 3 3 3 3 3 3 3 3 4 4 31 14 Core Regulatory Change 8 12 13 18 19 20 22 23 25 18 18 190 83 Favorable Capital Markets 8 13 13 20 21 22 23 24 25 18 18 196 89 Accelerated Adjustment 8 12 10 18 18 20 22 24 24 18 19 186 79

Differences over base scenario Core Regulatory Change 0 10 10 15 16 17 19 20 22 15 15 158 69 Favorable Capital Markets 0 10 10 17 18 19 20 21 22 14 14 165 74 Accelerated Adjustment 0 10 8 16 15 17 19 20 21 15 15 155 65

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SHADOW CORE EQUITY PRICE Base 9.3% 3.5% 2.1% 3.8% 5.0% 4.5% 3.7% 3.5% 3.7% 3.9% 3.9% 3.8% 3.8% Core Regulatory Change 9.3% 3.6% 9.9% 12.1% 4.7% 2.8% 3.7% 5.2% 5.4% 5.1% 5.0% 5.8% 6.6% Favorable Capital Markets 6.6% 3.7% 6.6% 8.0% 4.5% 3.4% 3.6% 4.0% 4.1% 4.1% 4.1% 4.6% 5.2% Accelerated Adjustment 9.3% 14.9% 0.6% 9.5% 2.8% 4.8% 4.1% 5.1% 5.0% 5.2% 5.1% 5.7% 6.5%

Differences over base scenario (basis points) Core Regulatory Change 0 5 775 831 -26 -172 7 173 164 126 117 200 283 Favorable Capital Markets -271 23 447 413 -51 -106 -7 51 38 25 27 86 145 Accelerated Adjustment 0 1142 -153 562 -219 30 44 166 127 129 126 195 272


Differences over base scenario (basis points) Core Regulatory Change 0 0 63 145 141 55 -36 -26 2 9 -3 35 81 Favorable Capital Markets 0 1 35 75 66 15 -36 -38 -32 -35 -45 1 38 Accelerated Adjustment 0 106 90 147 17 32 -31 -1 1 4 -6 36 78


Differences over base scenario Core Regulatory Change 0 -6 15 42 38 3 -35 -35 -28 -27 -31 -6 19 Favorable Capital Markets 0 0 12 27 23 3 -18 -20 -19 -18 -19 -3 13 Accelerated Adjustment 0 32 25 43 -6 -5 -33 -27 -29 -29 -33 -6 18

BANK RETURN ON EQUITY Base 6.4% 9.4% 6.0% 3.8% 4.9% 6.7% 7.1% 6.7% 6.5% 6.7% 6.9% 6.5% 6.2% Core Regulatory Change 6.4% 8.6% 7.7% 8.1% 8.0% 6.1% 3.2% 2.9% 3.5% 3.8% 3.6% 5.6% 7.7% Favorable Capital Markets 6.4% 9.3% 7.4% 6.5% 6.6% 6.0% 4.6% 4.1% 4.2% 4.4% 4.5% 5.8% 7.2% Accelerated Adjustment 6.4% 12.2% 8.2% 8.0% 4.0% 5.4% 3.4% 3.7% 3.4% 3.6% 3.5% 5.5% 7.5%

Differences over base scenario (percentage points) Core Regulatory Change 0.0% -0.7% 1.7% 4.3% 3.1% -0.6% -3.9% -3.8% -3.1% -2.9% -3.3% -0.9% 1.6% Favorable Capital Markets 0.0% -0.1% 1.4% 2.7% 1.7% -0.6% -2.6% -2.6% -2.3% -2.3% -2.4% -0.7% 1.0% Accelerated Adjustment 0.0% 2.9% 2.1% 4.1% -0.9% -1.3% -3.8% -3.1% -3.1% -3.1% -3.4% -1.0% 1.4%

CREDIT GROWTH TO PRIVATE SECTOR Base 5.4% 2.7% 2.7% 2.9% 2.9% 2.9% 3.0% 3.0% 3.0% 3.0% 3.0% 2.9% 2.8% Core Regulatory Change 5.4% 2.6% 2.3% 1.0% 1.6% 2.2% 2.7% 3.0% 3.4% 3.4% 3.3% 2.6% 1.9% Favorable Capital Markets 5.4% 2.7% 2.6% 2.7% 2.7% 2.8% 3.0% 3.2% 3.2% 3.1% 3.1% 2.9% 2.7% Accelerated Adjustment 5.4% 2.6% 0.5% 1.3% 0.6% 2.3% 3.0% 3.3% 3.2% 3.5% 3.4% 2.4% 1.4%

Differences over base scenario (percentage points) Core Regulatory Change 0.0% -0.1% -0.4% -1.9% -1.4% -0.8% -0.3% 0.0% 0.5% 0.5% 0.3% -0.3% -0.9% Favorable Capital Markets 0.0% 0.0% 0.0% -0.2% -0.2% -0.1% 0.1% 0.2% 0.2% 0.2% 0.1% 0.0% -0.1% Accelerated Adjustment 0.0% -0.1% -2.2% -1.6% -2.4% -0.7% 0.1% 0.3% 0.3% 0.5% 0.4% -0.5% -1.4%



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REAL GDP GROWTH (Y/Y) Base 2.9% 1.8% 1.8% 2.0% 2.0% 2.0% 2.0% 2.0% 2.0% 2.0% 2.0% 2.0% 1.9% Core Regulatory Change 2.9% 1.7% 1.5% 0.4% 0.8% 1.3% 1.8% 2.0% 2.4% 2.4% 2.3% 1.7% 1.2% Favorable Capital Markets 2.9% 1.8% 1.7% 1.8% 1.8% 1.9% 2.1% 2.2% 2.2% 2.1% 2.1% 2.0% 1.8% Accelerated Adjustment 2.9% 1.7% -0.1% 0.6% 0.0% 1.4% 2.1% 2.3% 2.2% 2.4% 2.3% 1.5% 0.7%

Differences over base scenario (percentage points) Core Regulatory Change 0.0% -0.1% -0.3% -1.6% -1.2% -0.7% -0.2% 0.0% 0.4% 0.4% 0.3% -0.3% -0.8% Favorable Capital Markets 0.0% 0.0% -0.1% -0.2% -0.2% -0.1% 0.1% 0.2% 0.2% 0.1% 0.1% 0.0% -0.1% Accelerated Adjustment 0.0% -0.1% -1.9% -1.4% -2.0% -0.6% 0.1% 0.3% 0.2% 0.4% 0.3% -0.5% -1.2%


Differences over base scenario (percent) Core Regulatory Change 0.0% -0.1% -0.4% -2.0% -3.1% -3.7% -3.9% -3.9% -3.5% -3.1% -2.9% -2.7% -1.8% Favorable Capital Markets 0.0% 0.0% -0.1% -0.2% -0.4% -0.5% -0.5% -0.3% -0.1% 0.0% 0.1% -0.2% -0.3% Accelerated Adjustment 0.0% -0.1% -1.9% -3.3% -5.2% -5.7% -5.6% -5.4% -5.1% -4.8% -4.5% -4.1% -3.2%

EMPLOYMENT GROWTH (Y/Y) Base 0.5% 1.3% 0.4% 0.4% 0.6% 0.6% 0.6% 0.6% 0.6% 0.6% 0.6% 0.6% 0.7% Core Regulatory Change 0.5% 1.2% 0.2% -0.3% -1.1% -0.5% 0.0% 0.4% 0.7% 1.0% 1.0% 0.3% -0.1% Favorable Capital Markets 0.5% 1.3% 0.3% 0.3% 0.4% 0.4% 0.5% 0.7% 0.8% 0.8% 0.7% 0.6% 0.6% Accelerated Adjustment 0.5% 1.2% -0.2% -1.5% -1.1% -1.2% 0.2% 0.7% 0.9% 0.9% 1.0% 0.1% -0.6%

Differences over base scenario (percentage points) Core Regulatory Change 0.0% 0.0% -0.2% -0.7% -1.7% -1.1% -0.6% -0.2% 0.1% 0.4% 0.4% -0.3% -0.7% Favorable Capital Markets 0.0% 0.0% 0.0% -0.1% -0.2% -0.2% -0.1% 0.1% 0.2% 0.2% 0.1% 0.0% -0.1% Accelerated Adjustment 0.0% 0.0% -0.6% -1.9% -1.7% -1.8% -0.4% 0.1% 0.3% 0.3% 0.4% -0.5% -1.2%


Differences over base scenario (thousand) Core Regulatory Change 0 -1 -7 -37 -104 -149 -174 -181 -176 -160 -145 Favorable Capital Markets 0 0 -1 -6 -14 -21 -24 -20 -12 -4 2 Accelerated Adjustment 0 -1 -26 -104 -172 -243 -261 -257 -247 -236 -220

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seCTion 6: assessinG The benefiTs of ReGulaToRy RefoRm: sTabiliTy pRospeCTs impRoved

68 of course, it might be argued that the achievement of greater stability through such a mechanism is a second-best outcome. The first-best approach would be to reduce macroeconomic errors and policy excesses in the first place.

any assessment of the economic costs associated with the regulatory reform process needs to be offset against the benefits that would result from the reform process. in this section, we turn to an assessment of the likely benefits of regulatory reform. our main thesis is that most studies of the benefits accruing from regulatory reform have tended to overestimate the likely benefits. we believe that other policies, such as effective macroprudential policies, could be considerably more powerful and effective in ensuring the stability of the financial sector.

The benefits of regulatory reform are best conceived of as stability benefits. in reducing the probability and cost of future bad outcomes (i.e., future financial crises), successful reforms would bring the benefit of a higher stream of future output and employment. Discounted back to the present, this future gain could well have a value that would exceed any cost borne in the meantime. in a sense, the macroeconomic costs associated with the regulatory reform process can be thought of as an insurance premium worth possibly paying to insure against the cost of a future crisis.

furthermore, these stability benefits can be thought of as accruing in two ways. first, higher capital and liquidity requirements and other restrictions on bank activity could make banks less liable to be a source of a costly future financial crisis. second, and perhaps more important, higher capital and liquidity requirements imply a greater degree of shock absorbency in the banking system. This would make the system better able to withstand the shocks that arise on a regular basis from other sources, most important, in recent years, macroeconomic policy mistakes and excesses. These greater buffers would make it more likely that the banking system would be able to avoid amplifying and propagating the shocks resulting from elsewhere in the economic system.68

studies measuring the benefits of reform produce a wide array of estimates, but most of them indicate sizeable gains. it should be noted, however, that these studies are generally carried out using a panel of data from a wide array of countries, often including emerging economies. in these studies, therefore, the

deep financial crises of the 1980s and 1990s that affected a number of specific economies are used to benchmark likely results for all economies.

The starting point for the analysis is an equation that says that the benefit of reform results from two factors: (a) the reduction in the probability of a crisis, Pc; and (b) the reduction in the output loss associated with a crisis, Lc. This benefit resulting from regulatory reform, R, can thus be written as:

∂Pc ∂LcbR = ––––––– Lc + ––––––– Pc (4) ∂R ∂R

it is helpful to consider each of these terms in turn.

6.1 aSSeSSing the impaCt of reform on the proBaBiLity of a future CriSiSempirical estimates of the effect of regulation on the probability of a crisis have been published in a number of studies. The most comprehensive survey was published by the basel Committee on banking supervision (bCbs 2010d). in that long-run impact study, the bCbs outlines a number of different approaches, the most common of which is to estimate a logit equation relating the probability of a crisis (proxied by the frequency of financial crises observed over a certain period and across a panel of countries) to leverage and liquidity ratios. other variables are added to this type of models to control for macroeconomic conditions and asset price developments. for example, barrel et al. (2009) use house price growth as one of the control variables. The bCbs long-run impact study uses both house price inflation and current account ratios. The key bCbs results are summarized in Table 6.1.

at first glance, these data would seem to highlight a very appealing result. based on the historic dataset, moving from a 6 percent capital ratio to a 7 percent ratio would imply a 2.6 percentage point reduction in the annual probability of a crisis. instead of a crisis happening, on average, every 13.9 years, one would occur every 21.7 years – which is roughly in line with the realized outcome over the data period in question

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69 see Tucker (2010) for a discussion of the role of the shadow banking sector during the crisis.70 perotti et al. (2011) set up a model in which banks’ optimal choice of capital is a function of the available risky investment opportunities. one

implication is that banks with excessive capital (compared to minimum regulatory requirements) may be induced to take excessive risk, as they attempt to put their capital to work.

(1980-2008). moving to a 9 percent capital ratio would reduce the annual probability of a crisis to about one quarter of the level implied by a 6 percent ratio, implying that a crisis would occur once every 53 years, rather than once every 14 or so. These models highlight diminishing returns, in the form of reduced crisis probability, beyond 10-11 percent capital ratios.

we have our concerns, however, that these results merely highlight historic experience. it is no coincidence that the model calibrates a 7 percent capital ratio with the probability of a crisis every 22 years or so, since these are precisely the average characteristics of the historic dataset. as a result, it is far from obvious that a move from a 6 percent capital ratio to a 9 percent ratio would cut the probability of a future crisis by about 75 percent.

higher capital ratios provide more insulation to banks, both against their own mistakes but also, importantly, against problems caused by economic volatility. as emphasized below, banking crises are generally not the exogenous starting point to broader financial crises, but rather are frequently part of the fallout from a broader crisis, which is often sparked by inappropriate monetary, fiscal and exchange rate policies. These policies create economic excesses that can then undermine asset values, including, but not limited to, bank claims on the government. This erosion of bank asset values then threatens banking sector solvency. This is why banks typically hold higher capital buffers in economies with a history of macroeconomic instability (e.g., emerging economies) or during periods of macroeconomic instability (e.g., in the united kingdom and united states before the 1960s).

The key issue is thus on whether and, if so, how the banking reform agenda might affect the probability

of a future crisis. we believe that there are five main channels of operation. Given that these do not all go in the same direction, even the sign of the change in probability with respect to a change in regulation is ambiguous. in other words, the sign of the first term in equation (4) could be negative:

• higher capital and liquidity buffers should improve banking sector resilience, both reducing the chances that the sector will be a source of future financial crisis or a propagator of future instability emanating from elsewhere in the economy. This effect is unambiguously crisis probability reducing.

• higher capital and liquidity buffers in the formal banking sector are apt to lead to disintermediation from the banking sector into less well-regulated and supervised non-bank debt intermediation channels. Quite how what is now sometimes referred to as a “shadow banking” system might develop under new, tougher regulations is hard to see ex ante, but recent consistent episodes of regulatory arbitrage make such disintermediation highly plausible.69 it is also not a given that the new financial firms that would develop under such disintermediation would be more unstable, although the history of such shadow firms and sectors is not encouraging. This effect could thus increase the probability of a crisis.70

• if, as we expect, higher capital and liquidity regulations raise the cost of credit to the private sector, then central bankers have made it clear that they would be willing to run an easier monetary policy than would otherwise be the case. such a low rate strategy would not necessarily be conducive to broader financial stability, however. it could not only foster excesses in the non-regulated, lightly supervised part of the private sector, but it also

Table 6.1: Annual Probability of a Banking Crisis for Given Capital Ratios (average across 6 models, no change in liquid assets assumed)

Capital Ratio 6 7 8 9 10 11 12 13 14 15

Implied probability of a banking crisis

7.2 4.6 3.0 1.9 1.4 1.0 0.7 0.5 0.4 0.3

Marginal reduction in probability resulting from an extra point of capital

.. 2.6 1.6 1.1 0.5 0.4 0.3 0.2 0.1 0.1

Implied regularity of a banking crisis (years)

13.9 21.7 33.3 52.6 71.4 100 143 200 250 333

source: bCbs (2010d), annex 2, Table 2.2, and iif staff estimates.

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71 see borio and Disyatat (2011).72 a good example of where the post-crisis trend in real growth was decisively lower is Japan, where real GDp growth averaged 4.4% in the 1980s, but

has averaged only 1.2% since. in that same period, however, Japan’s labor force growth slowed decisively and by the early 1990s the country had closed its technological gap with the united states in tradable goods.

could promote excessive flows to other economies – especially emerging economies, increasing the chances of a boom-bust cycle in those economies.71 once again, therefore, this effect could increase the probability of a crisis.

• The new capital and liquidity requirements add pressures on banks to increase their holding of sovereign bonds, as these are considered level 1 assets for the lCR calculation and are assigned a low risk-weight (see section 1). however, the recent european sovereign debt crisis has shown that sovereign debt is not necessarily as risk free and liquid as conventionally thought. Requiring banks to hold excessive amounts of these assets could add credit risk to their balance sheet and therefore negatively affect their future solvency. indeed, concerns about the exposure of other european banks to Greek debt (both public and private) contributed to the high volatility in banks’ equities at the height of the Greek crisis in July 2011. as with other forms of financial repression (Reinhart and sbrancia, 2011), artificially increasing the demand for government debt, while helping to keep monetary policy loose, might be counterproductive from a macroprudential perspective.

• while the banking industry recognizes the value of resolution plans involving bond holders as well as equity holders (see iif 2011b), the overall effect of deploying these measures is likely to be highly dependent on the underlying market conditions. in

the case of rapidly falling bank equity prices, it is possible that bond holders could perceive the safety of banks as having deteriorated. as bond holders fear bail-in plans could be activated, a run on banks’ debt market could follow, which could result in a banking crisis. hence, having resolution plans in place does not necessarily reduce the probability of a crisis.

6.2 aSSeSSing the CoSt of finanCiaL CriSeSempirical estimates of the cost of a banking crisis are crucially dependent on two sets of assumptions. first, a judgment needs to be made on where the economy stood on the eve of the crisis: was it operating at a “normal” level, only to be dragged down by the resulting financial crisis? or was it way over-extended – possibly as a result of overly expansive monetary policy – leaving it very vulnerable to a crisis driven primarily by a sobering up to more realistic expectations? in the first case, the costs of the crisis (in terms of GDp foregone) will be far more significant.

second, a judgment needs to be made on what impact the crisis had on the post-crisis trend rate of growth: was economic growth permanently damaged by the crisis, or did growth soon bounce back to the pre-crisis trend? if it did not, was that failure to revive to trend the result of the financial crisis, or was it caused by another factor?72

Chart 6.1 Measuring the Costs of Financial Crises

source: adapted from bCbs (2010d).

Crisis

Low Cost View

A

B

C

D Crisis

Old Trend

New Trend

High Cost View

A

B

C

D

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73 see panetta et al. (2009).74 see for example speeches by hoban (2011) and Šemeta (2011).75 There is some prospect that this will happen in the periphery of the euro area.

The importance of these two assumptions can be illustrated by the two panels in Chart 6.1 above, which provide two different estimates of the “cost” of financial crisis (in terms of output foregone shown in the shaded area) based on identical paths for actual GDP between the two series.

in the left-hand panel, the cost of the crisis is more in line with that of a normal recession: what is labeled as the start of the crisis (b) is akin to the bursting of a bubble, with unsustainably high levels of spending, output, and (presumably) tax revenues falling rapidly before growth recovers to its “original” trend (D). note that this subsequent trend growth rate is well below the growth rate observed in the boom period (a to b).

in the right-hand panel, however, the cost of the crisis is constructed to be more severe. The onset of the crisis (b) is reckoned to occur with the economy operating close to full employment (having closed a negative output gap between a and b). in the recovery phase, however (from D onwards), the economy is reckoned to grow at a far more meager rate, since it has been “permanently” damaged by the crisis. The shaded area in the right panel, therefore, is vast relative to that in the left, even though the actual GDp performance (which is all that is observable) is identical between the two examples.

This type of analysis is also important in the discussion of the public finance implications of the recent financial crisis. one important justification for significant regulatory reform often used by policy makers is that the public finance cost of financial support has been substantial.73 in most cases, however, the direct budgetary cost of financial sector support in 2007-2010 has turned out to be small and many governments have actually made a profit on their financial interventions.

Despite this, however, many officials point to the significant rise in public debt through the crisis period as an indirect measure of the cost to the taxpayer of financial sector support.74 This approach seems a little extreme, since it not only attributes the entire rise in public debt to support of the financial system, but, more important, pre-supposes that the public finance position as of the middle of 2007 was an equilibrium position. as many countries, especially in the euro area, are now becoming painfully aware, this was far from the true situation. more countries that thought that they were living in the world of the right panel (through point b) are now coming to realize that they were really in the world of the left panel.

a final, but also very important, consideration is that it is important to distinguish between genuine banking crises, which bank regulatory reform can presumably do something to prevent, and broader financial crises, of which a banking crisis becomes a component. as noted, it is possible that tougher bank regulations would help strengthen the banking sector sufficiently that it would be able to withstand other shocks, but it would seem somewhat extreme to lump in all output losses during crisis periods as due to banking crises, independent of their origin, as is done in most official studies on the costs of crises, and thus the benefits of reform.

a list of financial crises since 1980 is shown in Table 6.2 (next page). prior to the 2007-08 episode, most crises were the result of mismanaged public finances and, often, an unrealistic commitment to an exchange rate peg that, in turn, fostered irresponsible borrowing behavior in the non-financial corporate and household sector. when these public finance and exchange rate crises developed, local banking systems were generally taken down as collateral damage.75

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Table 6.2: Episodes of Systemic Banking Crises over the period 1980-2008

Country Start End Output loss Country Start End Output loss

Argentina 1980 1982 58% Mexico 1981 1985 27%

Argentina 1989 1991 13% Mexico 1994 1996 14%

Argentina 1995 1995 0% Netherlands 2008 … 25%

Argentina 2001 2003 71% Russia 1998 1998 0%

Belgium 2008 … 23% Russia 2008 … 0%

Brazil 1990 1994 62% Sweden 1991 1995 33%

Brazil 1994 1998 0% Sweden 2008 … 31%

France 2008 … 21% Switzerland 2008 … 0%

Germany 2008 … 19% Turkey 1982 1984 35%

India 1993 1993 0% Turkey 2000 2001 37%

Indonesia 1997 2001 69% United Kingdom 2007 … 24%

Japan 1997 2001 45% United States 1988 1988 0%

Korea 1997 1998 58% United States 2007 … 25%

Luxembourg 2008 … 47%

source: laeven and valencia (2010).

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seCTion 7: CompaRinG The iif woRk wiTh sTudies fRom The offiCial seCToR

76 The membership of the maG comprised experts from central banks and regulators in 15 countries and a number of international institutions.77 fsb/bCbs (2010b). note that the maG had published an interim study in august 2010 (fsb/bCbs 2010a). an updated study, incorporating the effects

of a sifi surcharge, is expected to be released in autumn 2011.78 The spreads increase and the fall in credit supply are median estimates across a range of models (see later discussion). The quoted numerical values

refer to a 4-year implementation timeline of the new requirements and are the values reached after 4 ½ years.79 see footnote 2, Graph 2, fsb/bCbs maG paper from august 2010, page 13; we are making the assumptions that these models relate to Japan and the

united states.

a number of studies of the macroeconomic impact of regulatory reform have been undertaken by researchers associated with public sector institutions. most notable among this group was the study of the macroeconomic assessment Group (maG), which was established by the financial stability board and the basel Committee on banking supervision.76 The maG published its final report assessing the impact of higher capital and liquidity requirements in December 2010.77 other studies of note include those undertaken by researchers at the oeCD, the imf, the european Commission and, in the united kingdom, at both the financial services authority (fsa) and the bank of england.

7.1 the BiS mag StuDyThe general methodology of the maG study was quite similar to our work. in both approaches, higher capital and liquidity requirements raise banks’ aggregate funding costs and squeeze net interest margins, leading to a combination of higher lending rates and lower credit volumes. This, in turn, restrains the path of GDp.

based on the limited amount of information provided with the bis study, however, a meaningful comparison with our own study is almost impossible. most important, absent a few specific cases cited (see below), there is no country-specific information. in general, however, the strong impression left by the maG analysis is that the macroeconomic impact of regulatory reform will be very modest. in the final report, the maG estimates that, for each percentage point increase in the minimum capital requirements, the level of GDp for the overall sample of countries analyzed would fall by a maximum of 0.19 percent compared to a baseline case, reflecting a 15 basis points increase in lending spreads and a 1.4 percent reduction in credit supply.78

The bis study used 97 models, covering 17 jurisdictions, whereas our work covers five. adding the studies done for individual euro area countries to those

done for the entire euro area by the eCb, the euro area accounts for a 44 out of the 97 models (a 45% weight). The united states accounts for 11, Japan accounts for 6, the united kingdom for 5 (switzerland was, for some reason, not included in the maG study). The sample of five countries in the iif study thus account for 66 out of the 97 country studies done in the bis-led work, or 68 percent. including more countries where the effects of basel iii are most likely smaller to non-existent, that is, korea (6), brazil (5), mexico (3), China, india, and Russia (2 each) would obviously help push the average result down.

7.1.1 Similarities between BiS and iif resultsat one level it is possible that the bis study contains estimates that are as significant, if not more so, than those contained in our own study. for example, two of the most negative estimates in the bis distribution come from models estimated by the bank of Japan and the federal Reserve.79

The bank of Japan model estimated that a 2 percentage point rise in the capital ratio would cause a 2.1 percentage point decline in GDp relative to the baseline over a 4 ½ year period. by contrast, our work points to a 4 percentage point decline in GDp relative to the baseline over a five year period in response to a whole set of regulatory measures that includes not just a 5 percentage point rise in minimum core Tier 1 capital, but also tougher liquidity regulations and, importantly for Japan, significant capital redefinition effects. To be sure, there were three other Japanese models developed as part of the bis-led work, which look to have produced less negative results but, as noted, the bis-led work would appear to encompass the iif work for Japan.

similarly, one of the fed models looks to have produced a GDp loss of about 1.8 percentage points over 4 ½ years in response to a 2 percentage point increase in the capital ratio, which compares to the

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82

80 The iif study uses predominantly eCb data.81 it should be pointed out that the eCb uses different models for computing the effects of capital regulations and for computing the effects of each of the

liquidity regulations. Therefore, simply summing the effects is likely to provide an overestimation of the increase in spreads.82 basel iii includes also a countercyclical capital buffer. however, based on a purely mechanical credit-to-GDp gap rule, in none of the five countries in

our study does the buffer need to be raised over the scenario horizon.83 in fact, it is likely that only a very small proportion of the models considered include liquidity effects.84 see fsb/bCbs (2010a) page 32.

estimate of cumulative loss of 2.7 percentage points over a five year period in the iif study. our higher number includes, however, the impact of redefinition of capital, tougher liquidity measures (both lCR and nsfR) and some estimates of the impact of separate national legislation (i.e. Dodd-frank).

in the case of the euro area, the bis-led analysis was apparently done by the eCb using data from the 20 largest complex banking groups.80 according to estimates provided in the maG paper, their statistical work showed that each percentage point increase in capital ratios would raise lending spreads by 28bps. The eCb also estimated that increasing liquid assets by 25 percent in an effort to meet the lCR would raise spreads by another 15bps. finally, adhering to the nsfR would cost somewhere between 57bps and 71bps. The implied net addition to lending spreads is 135bps,81 which compares with an estimated increase of 291bps in the iif study resulting from a wider range and larger scale of regulatory changes.

7.1.2 Differences between BiS and iif resultswhile it is thus possible to find our results buried somewhere in the bis study, there is no doubt that across the wide array of models used in the bis study (an average of 5.2 per jurisdiction), there are systematic differences that mean that the bis-led study produces a smaller negative impact from reform. in our view, these differences can be broken down into four main components:

• precise assumptions about regulatory change. The bis-led study is largely focused on the impact of higher regulatory capital ratios. These are just one of the four basel iii capital changes that we consider in the iif study. The others are (in order of importance): redefinition effects, higher trading book capital, and a range of capital buffers (mainly a capital conservation buffer and a sifi surcharge82). as noted in section 1, basel iii requires that, by 2019, the minimum total core Tier 1 capital ratio is raised by 5 percentage points. This would imply – on the basis on the “bis-median” of 0.19 percent off GDp for each point on capital – a 0.95 percentage point hit to GDp, which is still only about 30 percent of the iif estimate.

it is also somewhat unclear how much of the liquidity requirements embodied in the lCR and

nsfR measures are included in the bis study.83 To achieve the lCR, the bis study seems to have assumed a 25 percent increase in liquid asset holdings across all banking systems. This looks too low, especially for the euro area. our estimates suggest that the banking system would need to lift its liquid assets by 37 percent to come close to meeting the lCR. in meeting the nsfR, the euro area banking system would need to issue substantial amounts of long-term bonds.

finally, as discussed in section 1, it should be noted that we included in our work estimates of the impact from specific local legislation in the four of the five countries in our sample.

• Capital market implications of regulatory change. we do not seem to be in great disagreement about the amounts of new capital that will need to be raised. while the bis study is a little sketchy in detail on this issue, it notes, for example, that “the eCb estimated that a 2 percentage point increase in the target capital ratio would require the 20 largest banks in the euro area to accumulate roughly €114 billion in additional Tier 1 capital.”84 in our work, this amount is €480 billion over a 5-year horizon, partly reflecting substantial redefinition effects. what is more at issue are the terms of this issuance. in some of the models used by bis, the implication is that the primary market for these instruments is very elastic (i.e., a great deal can be raised at limited additional marginal cost). as discussed in section 4, such a benign outcome is encompassed by our shadow price framework, but it is only one among a range of possible outcomes, and one that we do not recognize as very likely, particularly given the current market conditions. ultimately, of course, this is an empirical issue.

we are also skeptical that the bis has come anywhere close to capturing the costs of enforcing the two key liquidity ratios – especially the cost (in terms of higher spreads) of substantially increased issuance of long-term debt. however, the key lesson of the bis study is perfectly aligned with what has been the iif position for awhile, that is, that it is necessary to give banks sufficient time to adjust. in the words of the bis authors: “but if banks attempt to make similar adjustments in a relatively short period of time, they may need to pay investors

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85 see fsb/bCbs (2010a) page 32.86 see slovik and Cournède (2011).87 note that in Chart 5.5 we take the oeCD multipliers to map our increase in lending rates into real economy effects. in Chart 7.1, the oeCD authors use our

multipliers to map the effect of basel iii on the lending rates and then process these lending rates changes through the oeCD macroeconomic model.

excess (sic) premia to induce them to make the corresponding shifts in their own portfolios. banks that find it expensive to raise new capital may be more likely to meet the requirements by cutting back on lending. These considerations suggest that modeled estimates may understate the impact of tighter bank regulations…The considerations do, however, counsel that a longer transition period might be preferable to a shorter one.”85

• monetary policy response. one reason for the low readings in a number of models and scenarios that the bis team runs is that their frameworks allow for a suitably aggressive monetary policy response. our work does not incorporate such effects as all scenarios for all countries are analyzed under the assumption of unchanged monetary policy. There are two reasons for our choice. first, it seems a little disingenuous to subtract from the negative impact of one policy change the positive effect that might accrue from another separate policy change when assessing the costs and benefits of the first change. second, and possibly more important, the assumption that there is latitude for a monetary policy response is looking increasingly questionable given the current economic prospects for the

majority of the countries in our study. indeed, since our work was first published, central banks in the major economies have come close to exhausting what latitude they had in conventional monetary policymaking, implying that the latitude for any offset in coming years will be very slim.

• The broader economic response to higher lending rates to the private sector. it is almost impossible to identify how much of the difference in the results between the two studies can be attributed to this factor, but it could be relevant. as discussed in section 5, the “multipliers” suggested by our results are in line with those discussed in the literature (e.g., oeCD).

7.2 oeCD StuDy of the maCroeConomiC impaCt of BaSeL iiieconomists at the oeCD86 have used the iif dataset provided in the June 2010 Interim Report to assess the macroeconomic impact of the basel iii reforms. They use the iif banking sector model and combine it with the oeCD macroeconomic model in a fashion similar to the exercise that we have conducted in our study (see Chart 5.5, page 58).87

-1.2

-1.0

-0.8

-0.6

-0.4

-0.2

0.0

Year 1 Year 2 Year 3 Year 4 Year 5

United States

Japan

Euro Area

G3 average

Year 5 Cumulative GDP loss

0.6%

0.5%

1.1%

0.8%

OECD Study: Impact of Basel III Regulatory Reform on the Level of G3 Real GDP percent deviations from baseline

Chart 7.1

sources: slovik and Cournède (2011) and iif staff calculation.

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84

88 These estimates reflect the authors’ assessment of how much higher bank lending rates affect whole economy borrowing costs, as well as the oeCD models’ elasticities relating GDp to whole economy borrowing costs. The us economy is more interest sensitive than the euro area and Japanese economies, but the euro area is most bank-dependent.

89 The model is calibrated on pre-crisis data from eight euro area countries’ banking sectors. The banks in the model play an intermediation role, collecting deposits from households/savers and lending to investment banks that, in turn, lend to entrepreneurs. Their pricing/lending decision is based on maximizing the stream of dividends paid to savers, subject to meeting a minimum deposit-to-loan ratio requirement and maintaining a fixed proportion of liquid assets.

90 The european Commission study only focuses on a basel iii-induced increase in capital ratio from the 2009 level of 5.7 percent to the basel iii core Tier 1 minimum of 7 percent. Their estimate implies that the required 1.3% increase in minimum requirements would result in a 0.2 percent GDp loss.

in the oeCD study, a 100 basis point increase in bank lending rates would subtract 18bps from annual GDp growth in the united states over a five year horizon. The respective impact for the euro area would be 42bps and 27bps for Japan.88 These estimates imply effects of changes associated with basel iii that are substantially larger than those provided by the bis maG. however, they are smaller than those we would estimate. The cumulative five-year GDp loss for the major economies for the full basel reforms is 79bps, relative to our initial June estimate of 310bps and our revised, current estimate of 320bps (Chart 7.1).

There would appear to be three main differences behind the results. first, the oeCD study does not take into account the possibility – which we see as very likely – that rising demands for both capital and liquidity will raise the marginal cost of funding to banks, thus boosting the necessary lending rate. second, the oeCD study appears to assume that other lending rates in the economy will be unaffected by bank regulatory reform. in our work, we assume some spillover. This is particularly important to raising whole economy lending rates in the united states, where the banking sector’s share of debt intermediation remains relatively low (see Table 2.1, page 36). finally, we believe that the oeCD study does not fully incorporate the impact of the wide array of international and country-specific reforms currently being discussed, in particular: capital add-ons (e.g., the sifi surcharge); tougher risk-weightings, which are quite burdensome for euro area banks; capital re-definition effects; tougher liquidity standards, which operate through squeezing banks’ net interest margins; and higher taxes.

7.3 imf CroSS-Country anaLySiS of BanKS’ reSponSeS to BaSeL iiia recent imf study (Cosimano and hakura 2011) estimates the impact of basel iii on banks’ holding of capital and on loan issuance using bank-level data. in this respect, the imf analysis departs from the bis, oeCD, and our own studies, which are conducted on consolidated country-level data. The imf assessment is based on an estimated three-equation model of banks’ behavior, in which banks are assumed to hold capital as a call option on future loans they could issue.

based on data for the world’s 100 largest banks (defined on the basis of 2006 assets), the paper finds that banks would need to raise lending rates by 16bps in order to meet basel iii minimum capital requirements. adding a 2.5 percent capital conservation buffer and a 2 percent sifi surcharge would increase lending rates by a total of 71bps. notice that if, as we do in our study, we assume that banks will be holding levels of capital above the minima in the form of national buffers, increasing the capital need by between 4.7 percent and 7 percent of Rwas (see Chart 2.8 page 37), then the total impact implied by the imf study could be an increase in the lending rate by as much as 84bps.

The study also estimates that a 16bps increase in lending rates would produce a 1.3 percent fall in the (long-run) level of credit, increasing to 5.8 percent when also including capital conservation and sifi surcharges. Contrary to the bis and oeCD studies, the imf paper does not attempt to assess the effects on the macroeconomy, although GDp growth and inflation are used as controls when estimating the econometric multipliers.

7.4 european CommiSSion StuDya special feature article in the first 2011 european Commission Quarterly Report on the Euro Area (see european Commission, 2011a) analyzes the impact of changes in capital requirements in the euro area banking sector using the Commission’s QuesT model. The model is a standard DsGe model of a closed economy augmented with a banking sector bloc.89

in the model, a 1 percentage point increase in capital requirements for euro area banks is estimated to increase the loan rate by 12bps, while also reducing the rate paid on deposits. The increase in the cost of capital has the effect of reducing investment, with this fall only partly compensated by the rise in consumption induced by the lower deposit rate. overall, the level of GDp is estimated to fall by around 0.15 percent after eight years. based on this estimate, a regulation-induced increase in capital needs of 5.5 percent of Rwas (see Chart 2.8 panel b)90 would then result in a 66bps increase in lending rates and a 0.83 percent fall in GDp.

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91 see barrel et al. (2009).

7.5 uK-SpeCifiC impaCt StuDieS7.5.1. fSa (2009)in July 2009, the uk fsa published the results of a cost-benefit analysis of capital and liquidity regulation conducted on their behalf by the niesR.91 using a version of niGem extended with a model of the uk banking sector, the study estimated the economic benefits and costs of enhanced regulation in the form of an increase in minimum (non-risk-based) capital and liquid assets ratios.

in the study, benefits of capital and liquidity regulations are assessed by first estimating the impact of leverage and liquidity ratios on the probability of a crisis using a logit model and data for a sample of 14 banking crises in 14 countries (see the discussion in section 6 for more details on this type of models). Controlling for real house price inflation, the study found that a 2-3 percentage point increase in regulatory ratios could reduce the probability of a systemic crisis in the united kingdom by between 50 percent and 70 percent.

in assessing the costs, the study used an approach that in many aspects is similar to an integrated version of our own, integrating the banking model into niGem. similar to our own approach, the channel through which tighter regulation affects the economy are higher funding costs requiring banks to charge higher spreads on their lending to households and companies. a 2-3 percentage point increase in uk capital and liquidity target ratios is found to reduce the level of real GDp by between 0.15 and 0.23 percentage points, compared to the baseline value over the long run.

putting these estimates together, combined with an estimate of the costs of output foregone due to a financial crisis (calibrated on the output costs of the 2008 crisis) so to assess the GDp gains of reducing the occurrence of a systemic crisis, the study found that a 3 percentage point increase in capital and liquidity requirements would amount to an optimal degree of regulation, delivering the highest net benefits, in terms of net present value of future output gains.

The fsa study stresses the many caveats, and related uncertainties underlying these cost-benefit estimates. in section 6 of this paper we have explained in some detail our reservations about the type of methodology for the benefits estimation used in the fsa study. Regarding the costs estimate, while acknowledging some similarity in the methodology used, we are unable to draw a direct comparison of the fsa study results with our own, given the different measures of capital and liquidity standards used.

7.5.2. miles et al. (2011)in this paper, the authors concentrate on capital regulation only. To determine the optimal level of capital that banks should hold, the authors conduct a cost-benefit analysis of having banks funding more of their assets with equity rather than debt. They conclude that even a doubling of bank capital, while increasing funding costs by only 10-40 bps – which implies minimal economic costs – would significantly reduce the probability of a financial crisis. Consequently, they support a level of capital holding by banks that is well above that of the recent past and also above the levels advocated by the basel iii package of capital reforms.

by concentrating on the long run, the study bases its estimate of costs around the modigliani-miller (m-m) theorem. To that end, the study first assesses the validity of the m-m hypothesis for uk banks by replicating the kashyap et al. (2010) analysis on uk data.

using data for six major banks over three years, the study finds a significant and positive relationship between bank leverage (defined as total assets to Tier 1 capital ratio) and bank equity beta, implying that an increase in the capital base would reduce banks’ riskness (as captured by the equity beta). following kashyap et al. (2010), this then maps into a significant and positive relationship between banks’ cost of capital and leverage, implying that an increase in the capital base (fall in leverage) leads to a fall in the cost of capital. The extent of that fall is taken as a measure of the validity of the m-m theorem for uk banks – between half and three quarter, depending on the model specification used.

The impact on output of the reduction in the cost of capital induced by higher capital holdings (i.e., the cost of higher capital requirements) is then assessed using a production function approach together with calibrated elasticities of output to capital and elasticity of substitution between capital and labor. The calculations in the paper suggest a linear relationship between changes in bank capital and permanent effects on output. in other terms, the marginal cost of bank capital is constant.

in assessing the benefits of higher capital, the paper first assesses the impact of higher capital on the probability of a banking crisis. it starts with the assumption that banking crises are likely to be determined by a generalized fall in banks’ assets value, where assets’ value (and risk-weighted assets) is, in turn, assumed to fall in line with permanent falls in output. hence, the study associates the probability distribution of annual GDp changes with the probability of banking crises, with the former calibrated using GDp data over

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86

92 also, it is not clear that structural changes in banks’ behavior or changes in accounting practices at banks, for instance, those affecting leverage measures, have been properly taken into account.

two centuries for a large group of countries. based on such distribution, the probability of a 15 percent fall in assets is estimated at 1.2 percent, requiring banks to hold at least 15 percent of capital to withstand such event. Conversely, if banks hold less than 15 percent of capital, a banking crisis occurs. The probability estimate is then combined with an estimate of the costs of a banking crisis – based on imf estimates as well as on the uk experience during the 2008 crisis – to derive an estimate of the benefits of additional capital in terms of reduced expected output loss. Given the distribution of banks’ assets shocks, the benefits of extra capital decline non-monotonically with the level of capital.

The optimal level of bank capital is finally determined by comparing these marginal benefits to the marginal costs computed earlier. The calibration used in the paper suggests that a 16 percent to 20 percent capital-to-Rwas ratio would be required to ensure positive net benefits, rising to 45 percent in the case of extreme negative output/assets shocks.

while remarkable for its careful and extensive analysis of several issues, the miles et al. (2011) paper – and, particularly, its conclusions – are dependent on the assumptions underlying the methodology and on the data used, especially the large database used for the benefits’ estimate.92 Concerns about the ability of these databases to convey precise information about pure banking crises have been discussed at length in section 6 of this paper. one important implication is that the degree of uncertainty surrounding the empirical estimates that provide the basis for the paper’s policy implications is potentially non-negligible.

* * * *

Table 7.1 provides a summary of the estimates of the impact of regulatory reforms provided in the bis, oeCD, imf and european Commission studies as well as our own study. Direct comparison is somewhat hazardous, given the different methodologies and samples used.

Table 7.1: Basel III Impacts – Comparison Across Studies Difference from baseline for all countries in each study. $ trillion for capital; basis points for lending rate; percent for credit and GDP volume; percentage point for GDP growth.

Impact on capital

Impact on lending rate

Impact on credit volume

Impact on GDP level

Impact on GDP growth

BIS(a) -- 15 -1.4% -0.19% -0.04%

OECD(b) -- 50 -- -- -0.79%

IMF(c) -- 71 -5.8% -- --

European Commission(d) -- 66 -- -0.83% --

IIF(e) 1.3 364 -4.8% -3.2% -0.7%(a) average yearly increase in lending rate; percentage deviation of GDp from baseline after 18 quarters on a 4-year transition period; year-on-year

average growth rate loss(b) estimate for 2015 (2019 for lending rate)(c) “long run” estimate(d) estimate after eight years(e) 2015 estimates for capital and real GDp level; 2011-15 average for all other variables. also includes country-specific regulatory changes.

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haldane, a.G. (2011). Risk off, bank of england, august.

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institute of international finance (2011b). Addressing Priority Issues in Cross-Border Resolution, may.

institute of international finance and oliver wyman inc. (2011c). The Implications of Financial Regulatory Reform for the Insurance Industry, august.

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J.p.morgan (2010a). Large Cap Banks, north america equity Research, January.

J.p.morgan (2010b). Global Banks – Too Big to Fail?, european equity Research, february.

Juneja, v., sung, p.p. and Carcuruto, T. (2010). Large Cap Banks; Regulatory Spotlight: Basel 3 – Preliminary Calculations for Tier 1 Cmn Hits State Street the Most, J.p. morgan north america equity Research, January.

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o’Donohoe, n., da silva, a. and Goel, a. (2010b). Global Banks – Too Big to Fail? Running the Numbers, J.p. morgan europe equity Research, february.

o’Donohoe, n., da silva, a. and Goel, a. (2010c). Global Banks – Too Big to Fail? A Review of Regulatory Proposals, J.p. morgan europe equity Research, february.

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90 panetta, f. et al. (2009). An Assessment of Financial Sector Rescue Programmes, bis papers, no. 48, July.

perotti, e., Ratnovski, l. and Razvan, v. (2011). Capital Regulation and Tail Risk, imf working paper, no. 188, august.

petajisto, a. (2009). Why Do Demand Curves for Stocks Slope Down?, Journal of financial and Quantitative analysis, 44(5), 1013-1044.

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samuels, s. et al. (2010). Not so Fast, Regulators: A €3 Trillion Funding Problem for European Banks, barclays Capital, June.

saurina, J. (2009a). Dynamic Provisioning: The Experience of Spain, Crisis Response note no. 7, financial and private sector Development vice presidency, world bank, washington DC.

saurina, J. (2009b). The Issue of Dynamic Provisioning. A Case Study, european Commission Conference, brussels, may 7th-8th.

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shleifer, a. (1986). Do Demand Curves for Stocks Slope Down?, Journal of finance, Xli, no.3, 579-590.

slovik, p. and Cournède, b. (2011). Macroeconomic Impact of Basel III, oeCD economics Department working papers no. 844.

standard&poors (2010). What Financial Reform Could Cost the Largest U.S. Banks, november.

swiss experts Commission (2010). Final Report of the Commission of Experts for Limiting the Economic Risks Posed by Large Companies, october.

Tarullo, D.k. (2008). Banking on Basel: The Future of International Financial Regulation, peterson institute for international economics, august.

Tarullo, D.k. (2010). Lessons from the Crisis Stress Tests, speech at the federal Reserve board international Research forum on monetary policy, washington DC, march.

Tucker, p. (2010). Shadow Banking, Capital Market and Financial Stability, Remarks at a bGC partners seminar, london, January 21st.

van hoose, D. (2007). Theories of Bank Behavior Under Capital Regulation, Journal of banking and finance, vol. 31, 3680-3697.

van steenis, h., Rehn, R., lofgren, p.k., Graseck, b.l. and pate, C.m. (2010). Banks Regulation, European Banks Most Challenged – Dividends at Risk, morgan stanley Research, January.

yellen, J. (2011). The Federal Reserve's Asset Purchase Program, speech at The brimmer policy forum, allied social science associations annual meeting, Denver, Colorado, January 8.

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abouhossein, k., lee, D., leech, C., worthington, k. and antunes da silva, C. (2009). Global Investment Banks, Switching Preference from IBs to Credit Banks on Regulatory Changes, J.p. morgan Global equity Research, september.

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bank for international settlements (2006b). Core Principles for Effective Banking Supervision, basel Committee on banking supervision, october.

bank for international settlements (2009a). Range of Practices and Issues in Economic Capital Frameworks, basel Committee on banking supervision, march.

bank for international settlements (2009b). Analysis of the Trading Book Quantitative Impact Study, basel Committee on banking supervision, october.

bank for international settlements (2009c). Strengthening the Resilience of the Banking Sector, Consultative Document, basel Committee on banking supervision, December.

bank for international settlements (2009d). International Framework for Liquidity Risk Measurement, Standards and Monitoring, Consultative Document, basel Committee on banking supervision, December.

barnes, R. (2010). Basel 3 for Global Banks: Third Time’s the Charm?, standard&poor’s Global Credit portal RatingsDirect, march.

barrell, R., Davis, e.p., karim, D. and liadze, i. (2009b). Banking Crises and Optimal Bank Regulation, national institute of economic and social Research.

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brender, a. and pisani, f. (2010). Global Imbalances and the Collapse of Globalised Finance. brussels: Centre for european policy studies.

brennan, m. (2010). Implications Of The December 2009 Basel III Proposals For Our Bank Hybrid Criteria, standard&poor’s Global Credit portal RatingsDirect, february.

brunnermeier, m., Crockett a., Goodhart C., persaud a. and shin, h.s. (2009). The Fundamental Principles of Financial Regulation, Geneva Reports on the world economy, no. 11, iCmb international Center for monetary and banking studies and CepR.

Caballero, R.J. (2009). Sudden Financial Arrest presented at the 2009 10th Jacques polak annual Research Conference, imf, washington, DC.

Calomiris, C. (2009). In the World of Banks, Bigger Can Be Better, The wall street Journal, october 20th, 2009.

Cecchetti, s.G., mohanty, m.s. and Zampolli, f. (2010). The Future of Public Debt: Prospects and Implications, mimeo, february.

Congressional budget office (2010). CBO’s Budgetary Treatment of Fannie Mae and Freddie Mac. Cbo background paper, January.

Date, R. (2009). A Capital Idea: Making Contingent Capital Less Contingent, Cambridge winter Center for financial institutions policy, october.

Davies, h. and Green, D. (2008). Global Financial Regulation: The Essential Guide. malden, ma: polity press.

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92 Deans, s. (2010). Basel Committee proposals: Accounting Perspective on Regulatory Capital Recommendations, J.p. morgan Global equity Research, January.

Disyatat, p. (2010). The Bank Lending Channel Revisited, bis working papers, no. 297, february.

Dromel, n., kolakez, e. and lehmann, e. (2009). Credit Constraints and the Persistence of Unemployment, iZa Discussion paper, no. 4501, march.

Duffie, D. (2010). The Failure Mechanics of Dealer Banks, Journal of Economic Perspectives, vol. 24, no. 1, 51-72.

european Commission (2010). Possible Further Changes to the Capital Requirements Directive.

fahlenbrach, R. and stulz, R.m. (2009). Bank CEO Incentives and the Credit Crisis, nbeR working paper, no. 15212, July.

flannery, m.J. (2005). No Pain, No Gain? Affecting Market Discipline via Reverse Convertible Debentures, Chapter 5 of hal scott. ed, Capital Adequacy Beyond Basle: Banking Securities and Insurance, oxford university press.

francis, w. and osborne, m. (2009). Bank Regulation, Capital and Credit Supply: Measuring the Impact of Prudential Standards, fsa occasional paper, no. 36, september.

furfine, C. (2000). Evidence on the Response of US Banks to Changes in Capital Requirements, bis working papers, no. 88, June.

Greenspan, a. (1999). Do Efficient Financial Markets Mitigate Financial Crises?, Remarks before the federal Reserve bank of atlanta, sea island, Georgia, october 19th.

Greenspan, a. (2005). Economic Flexibility, Remarks before the national italian american foundation, washington DC, october 12th

haldane, a.G. (2010). The $100 Billion Question, bank of england, march.

hansen, m. et al. (2009). Basel II and Securitization: A Guided Tour through a New Landscape, fitchRatings.com, october.

horiuchi, C., watanabe, m., Toritani, R., marshall, D. and hemsley, b. (2009a). Japan’s Major Banks FYR09: Remain Under Pressure, fitchRatings.com, June.

horiuchi, C., watanabe, m., Toritani, R. and marshall, D. (2009b). Japan’s Major Banks’ H1FYE10 Results: Weak Recovery on Course, fitchRatings.com, December.

institute of international finance (2008). Principles of Conduct and Best Practice Recommendations, final Report of the iif Committee on market best practices, July.

institute of international finance (2009a). Restoring Confidence, Creating Resilience, an industry perspective on the future of international financial Regulation and the search for stability, July.

institute of international finance (2009b). Reform in the Financial Services Industry: Strengthening Practices for a More Stable System, The Report of the iif steering Committee on implementation, December.

international monetary fund (2010a). World Economic Outlook, april.

international monetary fund (2010b). A Fair and Substantial Contribution by the Financial Sector, interim Report for the G-20, april.

Jackson, p. et al. (1999). Capital Requirements and Bank Behaviour: The Impact of the Basle Accord, basle Committee on banking supervision working papers, no. 1, april.

kacperczyk, m. and schnabl, p. (2010). When Safe Proved Risky: Commercial Paper during the Financial Crisis of 2007-2009, Journal of economic perspectives, vol. 24, no. 1, 29-50.

kay, J. (2009a). Narrow Banking: The Reform of Banking Regulation, Centre for the study of financial innovation, september.

kay, J. (2009b). The Future of Markets, wincott lecture, october.

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kayshap, a.k., Rajan, R.G. and stein, J.C. (2008). Rethinking Capital Regulation, paper presented at 2008 Jackson hole Conference, kansas City fed.

lakhani, k., Coombs, a., kalamboussis, k. and kanagasabapathy, s. (2010). Banking on Markets: The Year Ahead, Citigroup Global markets, January.

larosière, J. de (2009). Financial Regulators Must Take Care over Capital, financial Times, october 15th.

laux, C. and leuz, C. (2010). Did Fair-Value Accounting Contribute to the Financial Crisis?, Journal of economic perspectives, vol. 24, no. 1, 93-118.

lorenzen, h., king, m., Ghose, R., horowitz, k. and nedialkov, s. (2009). Re-plumbing the Financial System, Citigroup Global markets, september.

mach, T.l. and wolken, J.D. (2006). Financial Services Used by Small Businesses: Evidence from the 2003 Survey of Small Business Finances, federal Reserve bulletin, a167-a195, october.

miles D. (2009). The Future Financial Landscape. speech at bloomberg seminar, December 16th.

mitropoulos, a. et al. (2009). Basel II Supervisory Formula: The Meaning Behind the Maths, fitchRatings.com, october.

mora, n. and logan, a. (2010). Shocks to Bank Capital: Evidence from UK Banks at Home and Away, bank of england working paper, no. 387, march.

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paulson, h.m. (2010). On the Brink: Inside the Race to Stop the Collapse of the Global Financial System, business plus.

Ratnovski, l. and huang, R. (2009). Why are Canadian Banks More Resilient?, imf working paper, July.

Rennhack, R. et al (2009). Global Financial Regulatory Reform: Implications for Latin America and the Caribbean (LAC), imf staff position note, July.

Roxburgh, C. et al. (2010). Debt and Deleveraging: The Global Credit Bubble and its Economic Consequences, mckinsey Global institute, January.

samuels, s. et al. (2010a). European Banks: Surprise Surprise, Could Credit Quality be a Positive for 2010?, barclays Capital, January.

samuels, s. et al. (2010b). European Banks: Too Big to Fail, Are Large Banks a Problem?, barclays Capital, January.

samuels, s. et al. (2010c). European Banks: No Fun Funding, Winners and Losers in the Post Crisis World, barclays Capital, January.

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94

Mr. Zaffar Habib Manager Enterprise Wide Risk Strategy ANZ Banking Group Limited

Mr. Mickey Levy Chief Economist Bank of America

Mr. Julian Callow Chief European Economist Barclays Capital

Mr. Peter Redward Head of Emerging Asia Research Barclays Capital

Mr. Stephan Schmidt-Tank Director Group Strategy Barclays PLC

Ms. Maria Abascal Rojo Chief Economist - Regulation and Public Policy BBVA Research BBVA

Mrs. Mayte Ledo Turiel Chief Economist Chief Economist for Economic, Financial Scenarios and Regulation BBVA

Mr. Lawrence Uhlick Chairman BBVA Compass

Mr. Christian Lajoie Head of Group Prudential Affairs / Co-head of Group Prudential and Public Affairs BNP Paribas

Mr. Laurent Quignon Head of Banking Economics Economic Research Department BNP PARIBAS

Mr. Jordi Gual Chief Economist Research Department CaixaBank

Mr. Peter Munckton General Manager Group Strategy Commonwealth Bank of Australia

Dr. Andreas Gottschling Global Head ORM / RAI Deutsche Bank

Mr. Roar Hoff Executive Vice President, Head of Group Risk Analysis DnB NOR ASA

insTiTuTe of inTeRnaTional finanCe maCRoeConomiC effeCTs woRkinG GRoup

Chair Mr. Philip Suttle

Deputy Managing Director & Chief Economist Institute of International Finance

Deputy Chair Ms. Laura Piscitelli

Quantitative Modeling Specialist Global Macroeconomic Analysis Institute of International Finance

Committee Members

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Dr. Jan Holthusen Head Fixed Income Research DZ Bank

Dr. Josef Christl Advisor to the Managing Board Erste Group Bank AG

Mr. Rainer Münz Head of Research & Development Erste Group Bank AG

Mr. Gonzalo Gasos Seconded Adviser Banking Supervision European Banking Federation

Mr. Jan Hatzius US Chief Economist Goldman Sachs

Mr. Santiago Fernandez de Lis Chief Economist on Financial System and Regulation Grupo BBVA

Ms. Maria Victoria Santillana Senior Economist - Regulation and Public Policy Grupo BBVA

Mr. Stephen King Group Chief Economist HSBC Bank plc

Mr. Oscar Bernal Economist ING

Mr. Teunis Brosens Senior Economist Economics Department ING Group

Mr. Mark Cliffe Chief Economist ING Group Economics Department ING

Mr. Pieter Schermers Senior Analyst Capital Management ING Group

Mr. Peter Vanden Houte Chief Economist ING

Mr. Gregorio de Felice Head of Research Department Intesa Sanpaolo S.p.A

Dr. Giorgio Spriano Head of Risk Capital & Policies Risk Management Department Intesa Sanpaolo Group

Dr. Ilan Goldfajn Chief Economist Treasury / Macroeconomic Research Itaú Unibanco

Dr. Bruce C. Kasman Chief Economist J.P. Morgan Chase & Co.

Mr. Fernando Barnuevo Sebastian de Erice Managing Director Kleinwort Benson Advisers AG

Mr. Russell Deyell Head of Group Capital Management Group Corporate Treasury Lloyds Banking Group

Mrs. Cat Fereday Senior Manager, Group Regulatory Developments Group Corporate Affairs Lloyds Banking Group

Mr. Patrick Foley Chief Economist Lloyds Banking Group plc

Dr. Mark Lawrence Managing Director Mark Lawrence Group

Mr. Matthieu Lemerle Principal McKinsey & Company

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96 Mr. Satoshi Nakamura Manager Financial Planning Department Mitsubishi UFJ Financial Group

Mr. Kenichi Shuto Financial Planning Department Mitsubishi UFJ Financial Group

Mr. Akihiro Kitano Senior Manager Basel 2 Implementation Office Mitsubishi UFJ Financial Group, Inc.

Mr. Hideyuki Toriumi Senior Manager Basel 2 Implementation Office Mitsubishi UFJ Financial Group, Inc.

Mr. Takehiro Kabata Joint General Manager Corporate Planning Mizuho Financial Group

Mr. Naoaki Chisaka Senior Vice President Corporate Planning Division Mizuho Financial Group, Inc.

Ms. Candice Koederitz Managing Director and Global Head of Regulatory Implementation Morgan Stanley

Ms. Susan Revell Managing Director Morgan Stanley

Mr. David Russo Chief Financial Officer Institutional Morgan Stanley

Mr. Viswanathan Balram Chief Financial Officer – International Banking Group National Bank of Kuwait

Mr. Masaki Kuwahara Economic Structure Analysis Economic Research Department Nomura Securities International, Inc.

Mr. Paul Sheard Global Chief Economist and Head of Economic Research Nomura Securities International, Inc.

Mr. Itaru Yajima General Manager Economic, Finance & Investment Research Division Norinchukin Research Institute

Mr. Mark Weil Partner Oliver Wyman

Ms. Dawn Desjardins Assistant Chief Economist Royal Bank of Scotland

Ms. Kirsten Cornelson Economist RoyalBank of Scotland

Mr. Ralph Ricks Head, Group Regulatory Developments Group Regulatory Affairs Royal Bank of Scotland

Mr. Olivier Garnier Group Chief Economist Economic Research Société Générale

Mr. John Calverley Head of Macroeconomic Research Global Research Standard Chartered Bank

Mr. Kenichiro Mori Senior Vice President Office of Japanese Bankers Association, Corporate Planning Dept. Sumitomo Mitsui Banking Corporation

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Mr. Tetsuro Yoshino Joint General Manager Corporate Planning Department Sumitomo Mitsui Banking Corporation

Mr. Philippe Brahin Managing Director Head Governmental Affairs/Risk Management Swiss Reinsurance Company Ltd

Dr. Alberto Musalem Borrero Managing Director & Partner Tudor Investment Corporation

Mr. Yannick Oberson Analyst GGA UBS

Mr. Thomas Pohl Executive Director, Head Executive & International Affairs Group Governmental Affairs UBS AG

Mr. Enrico Piotto UBS AG, Financial Services Group

Ms. Micol Levi Consultant - Strategic and Regulatory Affairs Unicredit Group

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98 for the inStitute of internationaL finanCe:Philip Suttle Deputy managing Director and Chief economist

Laura Piscitelli Quantitative modeling specialist, Global macroeconomic analysis

Emre Tiftik Research assistant, Global macroeconomic analysis

proDuCtion:Litia Shaw staff assistant, Global macroeconomic analysis

pRojeCT Team

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insTiTuTe of inTeRnaTional finanCe1333 h Street, nw, Suite 800 east

washington DC 20005-4770tel: 202-857-3600 fax: 202-775-1430

www.iif.com

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