Rethinking Financial Stability
Speech given by
Andrew G Haldane, Chief Economist, Bank of England
Co-authored with David Aikman, Sujit Kapadia and Marc Hinterschweiger(1)
'Rethinking Macroeconomic Policy IV'
Conference, Washington, D.C.
Peterson Institute for International Economics
12 October 2017
(1)
All Bank of England. The views expressed in this paper are those of the authors, and not
necessarily those of the Bank of England or its committees. We are grateful to Andrew Bell,
Alex Brazier, Paul Brione, Marcus Buckmann, Oliver Bush, Patrick Calver, Shiv Chowla,
Sebastian de-Ramon, Stephen Dickinson, Nic Garbarino, Andrew Gracie, Amit Kothiyal,
Antoine Lallour, Katie Low, Damien Lynch, Clare Macallan, Alex Michie, Ali Moussavi, Casey Murphy,
Tobi Neumann, Simon Pittaway, Amar Radia, Ani Rajan, Katie Rismanchi, Fiona Shaikh and
Tamarah Shakir for comments and contributions. Philip Massoud and Karam Shergill provided
excellent research assistance.
Introduction
The theme of this conference is "Rethinking When it comes to financial stability,
Macroeconomic Policy".
that theme could hardly be more appropriate. The global financial crisis has been the prompt for a complete
rethink of financial stability and policies for achieving it. Over the course of the better part of a decade, a
deep and wide-ranging international regulatory reform effort has been underway, as great as any since the
Great Depression.
On cost grounds alone, a systematic rethink and reform of regulatory standards has been fully justified.
While the costs of the global financial crisis are still being counted, it seems likely they will be the largest
since at least the Great Depression. Two approaches are typically used to gauge these costs of crisis:
the cumulative loss of output relative to its trend and the cumulative fiscal costs of supporting the financial
Let's take these in turn.
system.1
Chart 1 looks at the path of output relative to a simple measure of its pre-crisis trend in the US, UK, France
and Germany after the Great Depression of 1929 and the Great Recession of 2008. In either case, it is
debatable whether estimated trends" were sustainable, as they may have been artificially inflated
"pre-crisis
by credit booms. Nonetheless, it is clear that the output losses from both crises, relative to pre-crisis trends,
have been extremely large and long-lasting.
In the US, the level of output is currently around 13% below a continuation of its pre-crisis trend. Ten years
into the Great Depression, output was around 28% below its pre-crisis trend. Even if not quite on the scale
of the 1930s, the global financial crisis has imposed a huge opportunity cost on US citizens. In the UK, the
losses since the Great Recession, currently at around 16% of pre-crisis GDP, are larger than in the US and
indeed larger than those that followed the Great Depression. The crisis opportunity costs for UK and
euro-area citizens have been the highest for at least a century.2
Much the same picture emerges if we look at measures of the fiscal cost of crisis. Again, there are a number
of methods for gauging this cost. But one simple metric is to look at the pattern of government debt-to-GDP
ratios after the Great Depression and Great Recession, recognising that the larger part of the debt
sustainability cost of crisis typically arises from the denominator shrinking than from the numerator rising.
Chart 2 plots these debt-to-GDP ratios, again for the US, UK, France and Germany.
It suggests that, in the decade after the Great Depression, levels of government debt relative to GDP had
increased by around 28 percentage points in the US, 9 percentage points in Germany, but actually declined
in the UK. Since the Great Recession, levels of debt relative to GDP have increased by, on average,
1
For example, Hoggarth, Reis and Saporta (2001).
2
Figures in this paragraph calculate a continuation of pre-crisis GDP using the average growth rate of output in the 10 years preceding
the crisis.
28 percentage points for the same set of countries. The fiscal cost of the Great Recession, at least on this
metric, is larger than during the Great Depression.
It is against this backdrop that policymakers internationally have engaged in a deep and wide rethink, rewrite
and reform of the global regulatory rules of the game. Wide, reflecting the multi-faceted nature of the
problems, market failures and market frictions exposed within the financial system during the crisis. Deep,
reflecting the severity of the hit to balance sheets, risk appetite and economic activity that the crisis has
inflicted and continues to inflict.
The next section reviews these regulatory reform efforts and their impact on bank balance sheets and market
metrics of banking risk. With a number of reforms yet to be fully enacted, it is too soon to be reaching
definitive conclusions. Nonetheless, some of the key questions thrown up by these regulatory reforms -
have almost a decade's worth of
conceptual, empirical and practical - are now reasonably clear. We also
additional evidence and research on which to draw when assessing these issues.
The following sections discuss some of those issues, drawing on new research and evidence: the calibration
of regulatory standards, balancing the costs and benefits of tighter regulation; the overall system of financial
regulation, balancing underlaps and overlaps, simplicity and complexity, discretion and rules; the impact of
reforms on incentives in the financial system, in particular incentives to avoid regulation; and the evolving
role of macroprudential regulation in safeguarding stability of the financial system.
The financial system is dynamic and adaptive. So any financial regulatory regime will itself need to be
adaptive if it is to contain risk within this system. In the terms used by Greenwood et al (2017), resilience
needs to be "dynamic". As past evidence has shown, too rigid a regulatory system will soon become otiose.
And there are already calls, in some quarters and in some countries, for a rethink and rewrite of regulatory
rules on which the ink is barely dry.3 This poses both opportunities and threats.
The opportunities arise from the need to keep the regulatory framework fresh and agile. With the best will in
the world, no one could say with certainty how the far-reaching and interwoven reforms to regulation over the
past decade will precisely land. Judging how the financial system might adapt to future trends in financial
technology is even harder to predict. As new evidence, incentives and innovation arise in the financial
system, the opportunity is created for regulators to learn and adapt the regulatory framework
(Carney, 2017a).
Equally, there are also threats to financial stability from any process of change. History is replete with
examples of regulatory standards being diluted or dismantled in the name of enhancing the dynamism of the
financial system and the economy. To follow this course unthinkingly would risk repeating regulatory
3
For example, Calomiris (2017), Greenwood et al (2017), Duffie (2017).
mistakes from the past, recent and distant. Only ten years on from the biggest crisis in several generations,
there are already some eerie echoes of those siren voices. With that in mind, we conclude with some
thoughts on issues which might be fruitful for future research on regulatory policy.
International Regulatory Reform
There are already a number of detailed accounts of the regulatory reforms undertaken by international
policymakers over the past decade (Carney (2017b), Duffie (2017), FSB (2017a), Greenwood et al (2017),
Sarin and Summers (2017), Yellen (2017)). The following is a summarised and simplified account of the
state of play. It partitions reform efforts into their microprudential and macroprudential components,
recognising that the two often overlap and are usually mutually reinforcing in their impact.
We focus here squarely on international banking regulation. We do not cover insurance regulation or
international accounting standards. We do not discuss regulatory reforms undertaken nationally, such as the
"Volcker Rule" in the US (Financial Stability Oversight Council and the "Vickers proposals" in the UK
(2011))
(Independent Commission on Banking (2011)). Nor do we discuss international reforms of market
- -
infrastructure for example, clearing and financial market instruments (FSB (2017b)). Finally, we do not
cover changes to banks' large exposures regime and a range of pay and governance reforms.
Microprudential Reform
Under the umbrella of Basel III, international reform of microprudential regulation has focused on four key
areas: capital, leverage, liquidity and resolution. Taking these in turn:
Reform of risk-based capital standards has focused on increasing the quantity and quality of capital held by
banks against their asset exposures. Minimum regulatory requirements for banks' "core" (common equity)
capital have been raised from 2% under Basel II to 4.5% under Basel III, even for the smallest banks. And
allowable deductions to core capital have been reduced. On quality of capital, the types of financial
instrument eligible as loss-absorbing capital (including for Tier 1) have been tightened considerably. For
example, certain hybrid capital instruments are no longer eligible, as they were shown during the crisis to be
Moody's
incapable of absorbing loss in situations of stress (Tucker (2013), (2010)).
These reforms to capital standards have, encouragingly, been implemented in full by nearly all countries
internationally (FSB (2017a)). Comparing regulatory capital, pre- and post-reform, is not straightforward.
But taking together changes in both the quantity and quality of capital, it has been estimated that Basel III
raised risk-based capital standards for globally systemic banks by a factor of around ten (Cecchetti (2015)).
One of the new elements of the Basel III package was to supplement risk-weighted capital standards with a
risk-unweighted leverage ratio. Because this measure does not require banks or regulators to form a
judgement on the riskiness of banks' assets, it is in principle simpler, more transparent and less subject to
risk-weight arbitrage (Haldane and Madouros (2012)). Indeed, those were among the reasons a number of
countries, including the US and Canada, had a leverage ratio regime ahead of the crisis.4 The Basel III
leverage ratio, set at a minimum level of 3% Tier 1, is due to be implemented internationally by 2018.
A second new element of the Basel III package was to augment solvency with liquidity-based standards.
Banks' liquidity has
long been a pre-occupation of the Basel Committee (Goodhart (2011)). But it took
wholesale liquidity runs on the world's largest
banks during the crisis to provide the impetus for
internationally-agreed liquidity standards. Under Basel III, these take the form of a liquidity coverage ratio
(LCR), designed to ensure banks have sufficient high-quality liquid assets to meet their 30-day liquidity
needs; and a net stable funding ratio (NSFR), designed to ensure banks' funding profiles are sustainable.
The LCR has been implemented in full in most countries; the NFSR is due for implementation by 2018.5
During the crisis, a crucial missing ingredient from the financial regulatory architecture was found to be the
-
ability to wind up financial institutions in an orderly fashion that is, while minimising disruption to financial
markets and the economy and without exposing tax-payers to risk (FSB (2014)). A number of measures
have been taken or are in progress to fill this gap, including the introduction of more effective national
resolution regimes for financial firms and greater cross-border co-operation and co-ordination when dealing
with international banks in situations of stress (FSB (2017c)).
liabilities which can be in the
Another element is to ensure banks have sufficient loss-absorbing "bailed-in"
event of failure, to prevent losses being shouldered by tax-payers. The Financial Stability Board has agreed
standards for such Total Loss-Absorbing Capacity (TLAC) for global systemically-important banks (G-SIBs).
These standards are to be phased-in over coming years, to reach a minimum level of 16% from 2019, and
of the resolution group's
18% from 2022, risk-weighted assets, as well as 6% and 6.75% on a leverage
exposure basis, respectively.
Macroprudential Reform
These new or augmented microprudential standards have been supplemented with a set of new
macroprudential measures. These focus on safeguarding the stability of the financial system as a whole
(Tucker (2009), Bank of England (2009, 2011)). The most significant of these reforms have focused on three
areas: macroprudential capital buffers; stress-testing; and shadow banks.
Historically, capital standards have been static requirements. As part of Basel III, a new time-varying
component of banks' capital was added -
the counter-cyclical capital buffer (CCyB). This recognises that
4
And a number of countries, including the UK, introduced leverage ratio capital requirements in the aftermath of the crisis.
5
For LCR, see BCBS (2013a): http://www.bis.org/publ/bcbs238.pdf; for NSFR, see BCBS (2014b):
http://www.bis.org/bcbs/publ/d295.htm
risks to the financial system vary over the credit cycle, typically being highest at its peak and lowest at its
trough. The CCyB aims to counteract somewhat that time-varying risk profile, with additional capital required
during the upswing which can be released during the downswing. There is international reciprocity in the
setting of the CCyB to reduce incentives for cross-border arbitrage (BCBS (2010a)). The framework has
been implemented in most jurisdictions.
Similarly, one of the key lessons of the crisis was that some institutions impose greater degrees of risk on the
system because of their size, complexity or interconnectedness (FSB (2010)). Basel III recognises the need
for these systemically-important firms to carry a structurally higher capital requirement, currently of up to
3.5%, to help mitigate the additional risk they bring to the system. These capital add-ons apply to the 30
designated global systemically-important banks (G-SIBs) and the roughly 160 domestic systemically-
important banks (D-SIBs), to be phased-in between 2016 and 2019.
Stress tests were used by regulators before the crisis to assess whether banks had sufficient capital to
withstand an adverse tail event. But these tests tended to be neither comprehensive nor transparent. In
2009, the US authorities undertook a comprehensive stress test of the major US banks and published the
results. For banks failing the test, regulatory restrictions on their behaviour were imposed. For some people,
this marked the turning point for the US financial system. A comprehensive annual stress-testing exercise is
now undertaken in the US.6 More recently, the US has been joined by the UK and the EU, among others.7
Finally, one of the striking features of the pre-crisis financial system was the emergence of the so-called
"shadow" banking system. In the US, on some definitions, this grew to exceed in size the conventional
banking system (Pozsar et al (2010)). Since the crisis, reform efforts have focused on two areas. First,
specific reforms have been enacted to sectors which, during the crisis, were found to contain fault-lines - for
example, Money Market Mutual Funds (IOSCO (2012)). Second, a framework has been put in place by the
FSB to define and measure shadow banking entities, to publish data on them to enhance market discipline
and to help authorities identify, and develop policy tools for mitigating, the risks they might pose (FSB
(2013a)). The FSB have recently put forward a package of recommendations to address structural
vulnerabilities from the asset management sector (FSB (2017d)).
Supporting this package of regulatory reforms, micro- and macroprudential, have been initiatives to boost the
quantity and quality of reporting by financial institutions. These should help in pricing institution-specific risk
by financial markets and ratings agencies. Notable initiatives have included: enhanced Pillar 3 disclosures
by banks, covering all aspects of the regulatory reform agenda; and the work of the Enhanced Disclosure
Task Force (EDTF), a private sector group established by the FSB. Over time, this has led to increased
compliance with the EDTF disclosure template (Chart 3).
6
The Comprehensive Capital Analysis and Review or CCAR.
7
Dent and Westwood (2016) includes a comparison of international concurrent stress-testing practices.
Balance Sheet Impact
overall resilience? One simple
So what has been the impact of these regulatory reform measures on banks'
set of resilience metrics focusses on bank balance sheet measures of solvency and liquidity. Comparisons
of international banks' balance sheets
are made difficult by changes over time in both the definitions of
variables and the sample of banks. We consider a panel of international banks, designated as either global
systemically-important (G-SIB) by the FSB in 2016, or domestic systemically-important (D-SIB). This gives a
panel of 30 G-SIBs and about 160 D-SIBs.8 For each bank, we consider two solvency-based metrics
(leverage and risk-weighted capital) and two liquidity-based metrics (a simple liquid asset ratio and the ratio
of loans to deposits). These measures do not map precisely to Basel definitions.9
looks at a measure of banks' Tier 1
Chart 4 risk-weighted capital ratios. For both G-SIBs and D-SIBs in our
sample, these have risen significantly over the past decade, almost doubling from around 7-8% to around
13-14%. A very similar picture emerges for leverage ratios (Chart 5). These have also roughly doubled over
the past decade, from around 3% to around 6%. On these metrics, there has been a material strengthening
in solvency-based standards among systemically-important banks over the past decade. This is also the
case for measures of TLAC (see Chart 6 for a sample of UK banks).
Liquidity metrics show a similar pattern of improvement. For example, liquid asset ratios - high-quality liquid
-
assets as a fraction of the total balance sheet have risen from around 6% in 2008 to more than 8% (Chart
7), though the increase is more muted for D-SIBs. Meanwhile, the ratio of loans to deposits (LTD) has also
improved, with lending backed by a larger share of stable sources of funding than before the crisis (Chart 8).
Market-Based Metrics
A second set of metrics of bank solvency and liquidity focus on financial market perceptions of bank risk.
There are a wide variety of potential such metrics, each with their own imperfections, including measures of
default such as CDS spreads, bond yields and ratings; measures of volatility, such as option-implied
volatilities; and measures of profitability, such as price-earnings ratios. These are summarised and
evaluated in Sarin and Summers (2016).
8
These banks have been identified based on publicly available lists of systemically-important firms:
• The Financial Stability Board's list of
G-SIBs as of 21 November 2016.
• O-SIIs notified to the European Banking Authority as of 25 April 2016.
• US bank holding companies (BHCs) subject to the Federal Reserve's annual Comprehensive Capital Analysis and Review
(CCAR) as of March 2014.
•
Banks designated as systemically-important financial groups by the Swiss National Bank.
• The four major banks in Australia.
•
The five largest banks in Canada.
These include bank holding companies as well as their primary operating companies where applicable, as well as foreign subsidiaries
that are explicitly designated as systemically-important for a particular country.
9
The data are from the Standard and Poor's Capital IQ database.
- -
Chart 9 plots a measure of default CDS spreads for a panel of G-SIBs. It shows a familiar pattern of
pre-crisis under-pricing of risk; a rapid re-pricing of default risk during the crisis; and a subsequent partial
unwind. CDS spreads today sit roughly midway between their pre-crisis and mid-crisis averages.
Bank bond spreads and ratings tell a similar story. Assuming pre-crisis banking risk was materially
under-priced, this evidence is consistent with regulatory reform having boosted the resilience of the global
banking system.
At the same time, measures of bank volatility and profitability have seen fewer signs of recovery. Chart 10
plots a measure of the price-to-book ratio of G-SIBs and D-SIBs. This currently lies well below its historic
average and little different than unity. Put differently, if we used a measure of banks' capital ratios using the
market rather than the book value of their equity, this would suggest a far smaller degree of improvement in
measured bank solvency and resilience (Chart 11), though the effect is less pronounced for D-SIBs.
Sarin and Summers (2016) reconcile these market movements by appealing to the shifts in the franchise
value of banks. Improved solvency standards have decreased the perceived default risk of banks. But
to banks'
coincident with lower risk are lower returns activities, due to the combined effects of stricter
regulation, misconduct fines, low levels of interest rates and increased competition. This leaves banks a
riskier proposition for equity investors than before the crisis, as the residual claimant on profits. But, by and
large, improved solvency standards have reduced risk among bond-holders and depositors in banks.
"By and large" because, accompanying these changes in banks' capital standards, has been a move
towards putting losses from default onto bond-holders. This can be seen in the evolution of the implied
"support ratings" given to banks major UK banks' debt enjoyed
by rating agencies. In 2010, holders of the
around 4 notches of implied ratings uplift owing to expectations of government support (Chart 12). By 2016,
that had fallen to less than one notch of support. A similar pattern is evident among other global banks.
Calibrating Regulatory Standards
Is the calibration of these new regulatory standards too tough, too lax or just right? That has been among
the most animated of the regulatory debates over the past decade. One standard for comparison is historical
experience. There has been a significant evolution in the levels of both capital and liquidity ratios of the
major banks over the past century. Chart 13 plots a measure of the leverage ratio for the UK and US
banking systems over a long historical sweep,10 while Chart 14 plots a simple measure of the liquidity ratio
for UK banks over the past half-century (see also Jordà et al (2017)).
Both solvency and liquidity ratios have exhibited a long, downwards drift. Between the end of the
10
Chart 13 is not directly comparable with Chart 5 because it is based on a different definition of leverage and sample of banks.
19th century and the troughs prior to the financial crisis, leverage ratios fell by around three quarters in the
US and the UK. Liquid asset ratios among UK banks underwent an even larger fall in less than half the
time. Given the scale of these falls, even with the regulatory reforms of the past decade, levels of capital and
liquidity in the banking system are at levels significantly below those 100 and 50 years ago, respectively.
On the face of it, this gives grounds for questioning whether even these revamped regulatory standards are
sufficient to withstand likely future shocks. We should, however, probably be cautious about jumping too
quickly to that conclusion. Over the past century, there has been significant change in the structure of the
financial system, including in the structure, scale and scope of financial regulation and the safety net. Those
changes could mean that simple, historical comparisons of regulatory standards are misleading.
Admati and Hellwig (2013) provide a comprehensive and lucid account of the case for higher capital
centres on the fact that the impact of higher capital standards on banks' overall
standards. Their argument
cost of capital needs to take account of the lower risk that arises from this shift - the Modigliani-Miller offset
(Modigliani and Miller (1958)). It needs also to distinguish between any private costs to banks from tighter
regulation and the social benefits this confers, with the latter the key public policy yardstick.
When it came to re-calibrating regulatory standards for capital and liquidity after the crisis, international
regulators engaged in a detailed, quantitative exercise which sought to weigh these social costs and benefits
of tighter regulation, drawing on existing empirical evidence. The Long-Term Economic Impact (LEI) study,
published by the Basel Committee in 2010, is a useful starting point for discussion of the appropriate
calibration of regulatory standards (BCBS (2010b)).
The main conclusion from this work was that, under conservative assumptions about likely economic costs,
there were positive economic benefits to society from a sizeable increase in the capital banks were required
to maintain. The study did not settle on an optimal level of bank capital. But the results presented were
consistent with societal benefits peaking at a Tier 1 risk-weighted capital ratio of between 16-19%.11 This is
most global banks' current
north of capital ratios.
The range of published estimates in the LEI study reflected different assumptions about the persistence of
the effects of crises on GDP, an area of particular empirical uncertainty in the academic literature. A
contemporaneous study by Miles et al (2013) concluded that optimal capital requirements were likely to be
-
higher perhaps around 20% - if account was taken of the offsetting risk and cost of capital effects of higher
solvency standards (the Modigliani-Miller offset).
It is useful to revisit the calibration in the LEI study in the light of subsequent research. A little notation may
be useful to organise this evidence. Suppose the aim of policy is to keep output in the economy, y, as close
11
These figures are expressed in terms of current definitions of capital and risk-weighted assets. The mapping from the estimates
reported in the LEI report and those above are due to Brooke et al (2015).
as possible to its trend growth path, y̅. The objective for the authorities is then to minimise a loss function,
which can be written as:
L = -
(yt y̅t)2
Let's simplify further and assume two factors can cause output to deviate from its trend: first, higher capital
requirements, k, which act to reduce output each period by δ; and second, the occurrence of a financial
crisis which, with probability γ, leads to a discrete drop in output of ∆. That is:
= - δk - γ(k)Δ(k)
yt y̅t
This captures the view that higher bank capital could reduce credit supply, and hence economic activity, in
the near term. But by making the financial system more resilient to future shocks, it may also reduce the tail
risk of bad macroeconomic outcomes.
Both probability and severity of crises are influenced negatively by the level of bank capital, with the
< 0, γ′′(k) > 0, ∆′(k) < 0, ∆′′(k) > -
relationship likely to be convex (γ′(k) 0) that is to say, one would expect
a one percentage point increase in the capital ratio to have a larger dampening impact on the probability and
severity of crisis when banks are close to their regulatory minima than when capital buffers are plentiful.
In this stylised set-up, the marginal condition that defines optimal bank capital is:
∂γ ∂Δ
δ = -Δ - γ
∂k ∂k
Optimal capital is higher the lower is δ, the economic cost of a marginal increase in capital requirements; the
∂γ ∂Δ
γ
greater are and Δ, the likelihood and severity of crises; and the greater are and the marginal effects
∂k ∂k,
of capital on the likelihood and severity of crises. So what have we learned over the past decade about the
likely magnitude of these parameters?
The Benefits of Higher Capital Requirements
The assumptions underpinning the marginal benefits of higher capital in the LEI study were as follows:
banking crises occur, on average, once every 20-25 years; the median estimate of the cumulative
discounted costs of a crisis is around 60% of annual pre-crisis GDP; each percentage point increase in the
capital ratio reduces the probability of a banking crisis by a smaller amount, ranging from 1.4% to 1% (for a
capital increase from 10% to 11%) to 0.4% to 0.3% (for a capital increase from 14% to 15%); and, finally,
the level of bank capital has no impact on the severity of crisis.
Since the LEI report, a rich seam of the literature has emerged on the determinants of crises and their
severity (∆). Some of the most illuminating pieces of this research have drawn on evidence from a long
historical time-series and across multiple countries (for example, Jordà et al (2013), Taylor (2015)). The key
findings are as follows.
First, credit booms are probably the single most important determinant both of the likelihood of crises and of
economic performance in the recovery after them (Schularick and Taylor (2012), Jordà et al (2013)). A
sustained 1 percentage point increase in the credit-to-GDP ratio raises the probability of crisis from 4% to
around 4.3% per year. It also raises the severity of a crisis, with real GDP per capita almost 1% lower after
five years.12 Colleagues at the Bank of England have considered whether it is the level of credit, or its
growth, prior to a crisis that matters most for subsequent economic performance (Bridges et al (2017)). They
find that credit growth has historically been a significant predictor of crisis severity, whereas the level of
indebtedness appears less important.
Second, not all forms of credit are equal. In the post-WWII era, mortgage credit growth has been the
dominant driver of financial crisis risk. And growth in mortgages, rather than in other forms of credit, is the
key determinant of the drag in the recovery phase from crisis (Jordà et al (2017)). Third, asset prices are
also important with 'leveraged bubbles' -
synchronised house price and mortgage credit booms - particularly
dangerous (Jordà et al (2015)).
Taken together, this evidence is consistent with the probability (γ) and output costs of credit crises (∆) being
at least as large as assumed in the original LEI study, perhaps larger, given the still-high levels of the
credit-to-GDP ratio in most countries, and the monetary and fiscal space available to the authorities at
-
present relative to the average of the past a recent paper by Romer and Romer (2017) presents evidence
that this factor is a significant determinant of crisis severity. The still-accumulating output losses during the
from this time's crisis would also point in this direction
recovery phase (Chart 1).
∂γ
What role does higher bank capital play in reducing the likelihood of financial crises ( or their severity (∂∆
∂k)?
∂k)
At least for the likelihood of crisis, subsequent evidence has tended to be rather ambiguous. Historical
evidence, using aggregate economy-wide covariates, has reached the perhaps surprising conclusion that
bank capital ratios have virtually no predictive power for the occurrence of financial crises in major advanced
∂γ
et al
economies (Jordà (2017)). That is, is indistinguishable from zero. This result holds both in the full
∂k
sample (1870-2013) and in the post-WWII period.
Micro-econometric studies on the link between bank failure and bank capital have found a more tangible
relationship, however. For example, Vazquez and Federico (2015) find that US and EU banks with stronger
12
This echoes and extends findings from earlier research by Borio and Lowe (2002), Borio and Lowe (2004) and Drehmann, Borio and
Tsatsaronis (2011), which found credit gap measures to be key determinants of crisis risk.
pre-crisis capital and structural liquidity positions were less likely to fail. Berger and Bouwman (2013) report
a similar finding using a longer-run data set of US banks. And a recent study by IMF economists finds that
risk-based capital ratios in the range 15-23% would have been sufficient to absorb losses in the vast majority
of past advanced economy banking crises (Dagher et al (2016)).13
At the time of the Basel Committee's study, there was little evidence on the impact of bank capital on the
severity of crises (∂∆ which is why this channel was ignored in the quantitative calibration. That has since
∂k),
changed. Jordà et al (2017) find that, while bank capital does not prevent a crisis from occurring, it matters
for the pain suffered in its aftermath. They find that real GDP per head is 5 per cent higher 5 years after the
onset of a crisis-related recession if bank capital is above its historical average when the crisis hits.