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

Banking regulations post-crisis and their effect on SME
lending

Robert E. Carpenter
Department of Economics, University of Maryland, Baltimore County
Lead Financial Economist, Supervision, Regulation, and Credit/Risk and
Policy, Federal Reserve Bank of Richmond

A very important disclaimer
• Everything I say is only my opinion and does not reflect
the opinion of the Federal Reserve Board or the Federal
Reserve Bank of Richmond
• Nothing I say should be interpreted as representing, or
even hinting at, the position of the US Government (which
I do not represent)
• The past two weeks and why I think it matters for people
interested in the growth of the SME sector

Confidential Information
Confidential Information 2

Our past month has been a busy one
• Worrying about the likelihood of success for the budget
negotiations between the President and Congress and the
consequences if they didn’t
• Worrying about the effects of S&P’s decision to downgrade
US debt from AAA to AA+
• Worrying about troubling data releases about the pace of
economic recovery both in the US and abroad
• More or less constant worry about the potential
consequences of the European sovereign debt crisis
• It seems almost quaint to talk about the implementation and
impact of new (and very important) regulatory capital
standards and its effect on lending and SME lending


I want to make 4 basic points
• Increasing the amount of capital banks are required to
hold and increasing its quality changes investor incentives
in a way that should reduce risk in the system, other things
being equal
• But there are, as always, tradeoffs
• The macroeconomic impact of Basel III should reduce
lending flows in addition to risk. However, estimates of
their size focus on prices as the margin of adjustment
(lending rates) not quantities
• This difference matters importantly for certain types of
enterprises


• Leaving countries free to determine the counter-cyclical
capital buffer provides them with some incentives that run
counter to promoting stability in a broad sense
• Instability affects risk appetitive, and SMEs are well known to
be risky ventures (just look at yesterdays data presentation)
• It is important that there be well understood definitions,
observable to market participants, that determine whether
a financial institution is a SIFI or G-SIFI
• Ambiguity in the definition of a SIFI (or GSIFI) may be
counterproductive


What is Basel III?
• Because this is a mixed conference, let me give a very
quick introduction
• Bank capital, in its simplest form, is the portion of the
banks assets that have no contractual commitment for
repayment
• Retained earnings or paid in capital are examples
• Bank capital serves as a shock absorber to protect against
declines in asset values, and therefore it protects
depositors against loss, or it protects the deposit insurance
fund


Incentives matter
• Shareholders, bank managers, depositors, and regulators
all have different incentives here
• The less capital held by banks, the more risk, but also
more return to owners because the bank is more highly
levered (concentrates gains on a narrower equity base)
• Since depositors are much like bond holders (and receive
a fixed claim) more risk provides them with little benefits
• Because more risk increases the probability of failure, it
increases the costs of failure, which include costs to the
deposit insurance fund and potential threats to systemic
stability
• Regulators require banks to hold minimum capital levels


What is Basel III, then?
• Basel III is the set of accords that layout minimum capital
levels relative to banks’ risk weighted assets
• The idea is that riskier assets require more capital to be held
against them (a bigger buffer)
• The noteworthy features of Basel III, not all of which I’ll cover
include
• Requiring much more, and higher quality capital
• A “capital conservation buffer” which, as it becomes depleted,
leads to restrictions on the bank to pay dividends
• A “countercyclical capital buffer” which is designed to slow the
flow of credit to overheated markets
• Two new liquidity standards to reduce the probability of a
“Lehman style” run on banks active in wholesale funding
markets

A summary sheet for Basel III


The economics of Basel III
• I have heard one comment many times; enough times that
I want to address it first
• “Basel III increases capital requirements, which will push
institutions subject to it further out on the risk curve”
• I understand the argument, but it is difficult to see how it
can be true in equilibrium.
• This issue split the conference I attended on my way here
• The easiest way to about this issue is to recall some basic
principles of finance


The basic argument
• ROE = ROA * EQUITY MULTIPLIER
• EQUITY MULTIPLIER = ASSETS / EQUITY
• So, if Basel III increases required capital, which it does,
the equity multiplier falls.
• If investors were to require the same ROE after
implementation, ROA must rise
• To raise ROA, other things constant, you must take on
additional risk


Why abandon the first principles of finance?
• One of the basic principles of finance is that earning a
higher return requires investors to bear more risk
• That concept operates in reverse, too
• If you bear less risk, you require a lower return
• What that means is as capital rises, investors should
respond by requiring lower ROA, in equilibrium
• The bottom line is that “skin in the game” matters for
incentives
• More skin in the game, i.e., more capital should reduce the
taste for risk
• There is a potential, then, for SMEs to see a decline in
lending that might be especially pronounced in bank
dependent systems

• Most estimates suggest that the increase in loan spreads that
result from Basel III will be relatively small
• Most estimates from the economics research literature suggest
that capital spending (plant and equipment) is interest inelastic
(insensitive to changes in interest rates)
• Put a small change in interest rates together with investment
that is insensitive to changes in interest rates and you get a
small macroeconomic impact
• The big question in my mind is what sorts of activities, or
loans, institutions will shed disproportionately as they reduce
their risk profiles?
• The second big question is what the margin of adjustment will
be, prices or quantities
• It matters. But more on this later


Some detail on the macroeconomic impact
• OECD: Banks pass on their higher funding costs through
higher 15bps loan spreads. Reduces GDP growth by 5-
15bps per year during the rollout
• Banca d’Italia: 3-39bps of reduced GDP per percentage
point of increased capital, 0-5bps of reduced GDP growth
per percentage point of increased capital
• NY Federal Reserve: 9bps reduced GDP per percentage
point in increased capital. An additional 8 bps reduced
GDP attributable to the new liquidity standards.
“Consistent with the Macroeconomic Assessment Group
(MAG)” of the BIS


What’s the big picture from all of this?
• First, the effect of the higher capital requirements is on the
level of GDP during the transition period, also the growth
• From a big-picture macroeconomic modelling perspective,
this is as it should be. Macroeconomic growth rates, in these
models, shouldn’t be lower after the phase in
• Second, it is fair to say that the macroeconomic costs
estimated by the most of the models are modest
• The models don’t necessarily account for the facts that many
institutions may not find the Basel regulatory constraints
binding. Markets may well require (and in fact do appear to
require) institutions to hold capital in excess of the minimums
• Lastly, in economics we usually think of benefits net of
costs, or costs net of benefits. Most of these models
recognize, but do not calculate, the benefits of Basel III


Some caveats worth thinking about
• Even though the transition period costs are modest per
percentage point of additional capital, the timing is
unfortunate, as many advanced economies are growing
quite slowly
• Firms that depend on internal funds for growth are
particularly impacted, as well as those entrepreneurial firms
that depend on using household assets as collateral
• What are the size of the net costs (or benefits) of Basel
III?
• BIII should reduce risk. From a theory standpoint reducing
risk means reducing volatility. From a practical standpoint
that means reducing the output costs of financial shocks
• How big are those benefits? It depends on the shape of
recessions caused by the shocks. The benefits of reducing
negative shocks is bigger the bigger they are and the longer
their duration (the current shock is both big and long)

More tradeoffs: troughs and peaks
• While BIII should help to shave the bottom off future
troughs, will it also shave some of the tops from future
peaks?
• Counter cyclical capital charges of 0-2.5% are to be levied
during periods of “excess” credit growth
• Laudable goal of reducing pro-cyclicality of capital
• Also have the impact of reducing the flow of credit in markets
that might be “overheating”


Two reasons for rapid credit growth
• Credit may grow rapidly in a sector if incentives are
misaligned and the financial asset in question is more
opaque for sellers than it is for buyers.
• Many have argued this combination existed in mortgage markets
• Credit may also grow rapidly in a sector where there is a
technological innovation that increases productivity or
returns
• Efficient capital markets will provide capital to markets with
high returns…rapidly, if investors and entrepreneurs
believe that there are first mover advantages
• Asset prices may also rise rapidly, and no doubt many observers
will characterize this as a “bubble” especially if as a result of an
industry shakeout over standards or production technology, some
early entrants to the industry exit it
• I would not like the job of having to separate “bubbles” from
innovations

The countercyclical capital buffer
• Is designed to slow the supply of credit when it is
expanding rapidly
• Will that slow the pace of developing newly identified
innovations (which often take place in SMEs)?
• Will it change the dynamics of innovations, by raising entry
barriers to late entrants, who may have superior
technologies?
• My point is to state simply that reducing risk/variance
through counter cyclical capital buffer has more than one
impact
• Measures to reduce the variance of output by slowing the
supply of credit when it is growing rapidly may reduce the
number of observations we see in the left tail, but may also
reduce the number of observations we see in the right


Opportunities for mischief
• Because the counter cyclical capital buffer can be
“implemented according to national circumstance” it
introduces the possibility of setting the buffers size based
on factors other than promoting stability
• Take two countries: A and B. Country A has the (A)verage
countries view about stability. Country G values (G)rowth
in its financial sector for economic or political reasons


Coordination problems
• Suppose an apparent technical innovation occurs, which
leads to a rapid flow of lending into that sector
• Country A, because it values stability, may implement a
high countercyclical buffer. Country G may see this as an
opportunity to increase the prominence of its financial
sector and set a lower buffer
• If G’s banks receive funding from A’s, it also passes some of
the cost of that choice to A, in effect borrowing a portion of
the buffer
• While in principle international coordination would be a
solution, it also assumes away the problem (that countries
with different objectives may choose not to coordinate)


The methodology to identify SIFIs and GSIFIs
• There’s agreement that “Systematically Important
Financial Institutions” should have to hold capital in excess
of the minimums
• What incentives does an institution have?
• Does it want to be categorized as a GSIFI?
• If it does, it will be subject to a higher amount of regulatory
scrutiny, and it will be subject to the higher capital
requirements associated with being a SIFI
• On the other hand, GSIFIs might be viewed as being more
likely to receive support in the event of a financial shock, and
this support might lead it to be able to attract funds at below
market rates
• More likely to have access to the safety net


Why transparency is important
• The best of both worlds might be for a firm to become
large enough so there is some uncertainty about whether it
is a GSIFI
• In that case
• Market participants might believe that there is a good
probability that it would receive support in the event of a
systemic shock
• But it might not be so large that it incurs the extra regulatory
scrutiny or GSIFI capital charge
• You might argue that a public list solves this problem, but I
would respond it is the firms that are almost on the list that
I am concerned about
• A transparent methodology, and a credible commitment not to
treat near SIFIs as SIFIs in a shock, is helpful

Some “finer” macroeconomic details
• Recall that most (but not all) estimates of the
macroeconomic impact of BIII focused on increases in
lending rates
• If investment is interest inelastic (and there is a great deal of
evidence from the academic literature suggesting that its is)
then small changes in interest rates lead to small changes in
investment
• Hence the small estimated impacts
• Not everyone, in either policy circles or in academics,
views focusing on interest rates as the margin of
adjustment is a complete story


Quantities matter
• There is an important literature in economics (where two
Nobel prize winners work) that argues interest rates aren’t
always used to ration credit in financial markets
• Adverse selection and moral hazard, coupled with
asymmetric information between borrowers and lenders
means that increasing interest rates can lower borrower
returns
• In that case, they may employ “credit rationing” to allocate
credit.
• Since most of the models estimating the macro effect of
BIII do not consider this channel, they may not capture the
full output costs of higher capital standard


What sort of firms, what kind of output costs?
• The research literature in economics has suggests that
small, entrepreneurial firms face difficulties in attracting
outside financing
• If the adjustment margin to BIII is quantities (reduced
availability) it may slow the birth of new firms or reduce the
growth of SMEs
• SMEs are often the focus of economic development policies and
sometimes account for a great deal of gross (but not necessarily
net) job formation
• The potential output costs are larger for firms operate in
economic systems where alternatives to bank finance are
less available
• The standard examples of bank dependent economies those
of continental Europe
• What’s the potential distributional impact across countries?

Some final thoughts
• Basel III is quite complicated, it’s implementation is
complicated, measuring it’s output costs is complicated,
predicting institutions, and regulators, reactions to it is
complicated, and it’s being implemented in a complicated
environment
• But one thing that isn’t particularly complicated is that
more capital, and higher quality capital, should reduce the
risk of costly financial shocks
• Those costly financial shocks have a particularly large impact
on entrepreneurial ventures, both in formation rates and
survival rates
• The tradeoff is how the response of the financial system will
affect to regulatory reform will effect the growth and survival
of SMEs going forward, and so your work is more important
than ever


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

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

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