Vítor Constâncio: Financial regulation and the global recovery
Speech by Mr Vítor Constâncio, Vice-President of the European Central Bank, at the
24th Annual Hyman P. Minsky Conference "Is financial reregulation holding back finance for
the global recovery?", Washington DC, 16 April 2015.
This is the full text of a speech delivered in abridged form in Washington on 16 April.
* * *
Ladies and gentlemen,
Let me begin by thanking the Levy Institute and specially its President, Dimitri Papadimitriou,
for inviting me to speak again at the Annual Conference honouring Hyman Minsky. This
year's theme is quite topical and opens the door to a lively debate about the role of finance
and regulation, both in the crisis period and in the moderate recovery underway. The
recovery is however still to achieve the closing of negative output gaps on both sides of the
Atlantic. It could then be expected that different views emerge about the regulatory reform
efforts that are not yet concluded. Let me mention four.
According to one view, the crisis and its recessionary effects result from the excesses of
finance and insufficient regulation. This implies that the main effort should be to tame finance
in order to avoid future crises of the same type. In this vein, it could be expected that deep
reforms of the international financial regulation would follow the acknowledged failure of the
legal framework in place before the crisis. Two well-known specialists in the field, Barry
Eichengreen and Eric Helleiner have very recently published two books1 explaining why a
transformative reform of the international system has indeed not occurred. Eichengreen
explains it the following way: "...depression and financial collapse were avoided, if barely.
This fostered the belief that the flaws of the prevailing system were less. It weakened the
argument for radical action [...]. Success thus became the mother of failure."
This sounds perhaps too harsh because good work has been done in adopting measures in
the domains of capital, liquidity and resolution of banks in order to increase the resilience of
the banking sector, within the financial system. Much less has been achieved beyond banks,
notably in what regards OTC derivatives or non-bank entities, including activities of the
socalled shadow banking.
However, as remarked by Helleiner, financial reform saw the emergence of a promising
innovation in the form of macro-prudential policy: a policy that uses regulatory measures to
deal with system-wide financial risk and the smoothing of the financial cycle, i.e. the
fluctuations of credit financing, leverage and asset prices. This goal is essential.
Nevertheless, some economists and policy makers continue to view this with scepticism.
Monetary policy cannot simultaneously cope with two different objectives and the need for
macro-prudential policy has become more acute with the realisation that advanced
economies are very likely to face a prolonged period of low real and nominal growth. In such
an environment, monetary policy has to remain accommodative, with low interest rates which
foster search for yield and froth in asset markets, making the use of macro-prudential policy
- to strengthen institutions, to smooth the financial cycle and to pre-empt asset bubbles -
more necessary. Without an effective macro-prudential policy, advanced economies will not
be able to avoid financial instability. This means that regulatory reform has to continue until
appropriate instruments are put in place to deal with the non-bank financial sector, which is
increasingly taking the role of credit intermediation previously performed by banks. The
concentration of reform measures on the banking sector has led to an expansion of shadow
banking or the market-based financing sector. The investment fund industry doubled in size
in the last five years in Europe. The financial system is expanding in new dimensions and
new risks are emerging in terms of maturity transformation and leverage, especially synthetic
leverage.
Another view on the regulatory reform is rooted on a sceptical perspective about the
possibility of taming finance, accepting that booms and busts are simply unavoidable. After
adopting some measures to increase the resilience of financial institutions in terms of capital
and liquidity, the policy concern is about how macroeconomic policy should be used to
mitigate the effects on the real economy stemming from endogenous financial crises.
Monetary policy would "mop-up the mess" via liquidity provision after the bust and would help
the recovery. For the more Keynesian-inclined minds, this should extend to the use of fiscal
policy, especially in an environment of low interest rates near the zero lower bound.
It is true that monetary policy is nowadays considered the most powerful of the macro
policies to stabilise the economy, but it is important to be aware of its limitations, especially
near the zero lower bound. It is sometimes said that the world avoided the worst in 2008 only
because central banks made bold use of their tools, notably by cutting rates and providing
abundant liquidity. But the truth is that without the significant use of fiscal policy in 2008 and
2009, stimulating our economies and supporting the banking sector, the meltdown of the
financial system would perhaps not have been avoided. At the meeting in Toronto in 2010,
the G20 decided to reverse this policy and embarked in fiscal consolidation, to different
degrees, leaving monetary policy alone to deal with macroeconomic stabilisation. In this
context, the double dip suffered by the euro area economy after 2011 is easier to explain by
fiscal policy short-term effects, than by the behaviour of monetary policy. In a European
Commission (EC) working paper2 using the EC Quest model, Jan Veld finds that the
cumulative impact from simultaneous fiscal consolidation in 2011 to 2013 (taking into
account spillover effects among seven euro area countries), ranged from 8.1 % in Germany
or 9.7% in Spain to 18% in Greece, in terms of GDP losses in relation to baseline. In the
same vein, Rannenberg, Schoderand and Strasky (2014)3 find a cumulative negative effect
of consolidation for the euro area in 2011-2013 of 14%, using a variant of the Quest model,
and of 15% using a variant of the ECB's New Area-Wide Model (NAWM). Despite the fact
that several European countries had to implement deficit reductions, these model-based
calculations, with all their caveats, illustrate the importance of macroeconomic policy in
determining the outcome of financial crises for the real economy.
Coming back to the conference theme, a third view about the regulatory reform, supports a
positive answer to the question: "Is financial reregulation holding back finance for the global
recovery?". It concludes that regulatory reform has gone too far and that by constraining
finance it is hampering the recovery. However, it would first have to be proven that
investment and growth are being significantly affected by financing supply constraints in
order to validate this view.
This does not seem to be the case. Evidence points more in the direction of a general lack of
demand and weak growth prospects to explain low investment and the modest recovery. The
desperate search for growth and jobs by governments and policy makers, following seven
years of gradual reforms, could give some credence to this view amidst feelings of reform
fatigue. However, I argue that it would be wrong to listen to these opinions. The pace of the
recovery is not being affected by lack of finance. Finance would be abundant if there were
investment projects with prospects of good return.
A fourth possible answer to the conference's question relates to a "liquidationist" view that
amazingly surfaced again, in spite of the lessons from the 1930's. Its defenders claim that
macroeconomic policies, aimed at mitigating the recessionary consequences of the crisis, do
more harm than good in the medium-term. However, some accept that reforms to strengthen
capital and liquidity buffers in credit institutions were necessary. According to this view, the
crisis stemmed from excessive credit, debt and bad investments and thus, deleveraging and
liquidation of bad capital must happen. Applying a very accommodative monetary policy to
fight recession would risk inflation or, in the more modern guise of the doctrine, would lead to
asset price bubbles and future crises. Consequently, monetary policy, in view of the alleged
ineffectiveness of macro-prudential policy, should have become restrictive since 2011 or
2012. According to this reasoning, precedence should be given to the financial cycle over the
stabilisation of the business cycle or, in more telling terms, precedence should be given to
the risk of asset price bubbles over the risks of deflation and unemployment.
Acknowledging that my description of these four different opinions has hardly been neutral, in
my view, a combination of the first and second approaches is the appropriate response to the
question setting the conference theme. Nevertheless, I want to clearly state that the financial
regulatory reform has to be completed and extended through further efforts to contain risks in
the so called shadow banking sector and to strengthen macro-prudential policies. Believing
that advanced economies face a protracted period of low growth that requires
accommodative monetary policy, I see no alternative to regulatory macro-prudential
instruments to mitigate financial instability and crises by smoothening the financial cycle.
Naturally, we should be aware that taming finance is a challenging, if ever achievable task.
As Minsky put it in the last sentence of his book "Stabilizing an unstable economy": "There is
no possibility that we can ever set things right once and for all; instability, put to rest by a set
of reforms will, after time, emerge in a new guise". Nevertheless, our countries have
experienced long tranquil periods, without financial crises in the past, and we should now aim
to return to that.
I already stated that re-regulating finance is, in my view, not an obstacle to the ongoing
recovery. In last year's conference, I argued that "fixing finance" was not enough to ensure
higher economic growth.4 This does not mean that I do not consider finance vital for a
healthy economy. A well-functioning financial system is essential to foster long-term
economic growth. In this respect, last autumn was characterised by two milestones in
Europe: the completion of the asset quality review and stress tests and the start of the Single
Supervisory Mechanism, which went live on 4 November. Repairing banks' balance-sheets,
together with the advancements in the design of the new resolution framework, the
regulatory reforms improving capital and liquidity standards, as well as those concerning the
shadow banking system (like securitisation and OTC reforms), constitute clear evidence of
the commitment of the ECB and other EU policy makers to restore a well-functioning
financial sector and create the conditions for an adequate flow of credit to the real economy.
These successes took place against the background of slow growth and subdued inflation.
Despite recent encouraging signs, the recovery in Europe remains gradual and moderate. In
the European context, the subject of this conference is therefore very pertinent. I already
gave my general answer in favour of completing the regulatory reform. In what follows, I will
further substantiate my arguments in favour of that position and will express my concern with
the insufficient attention paid so far to the growing risks in the shadow banking sector.
A defence of regulatory reform
The beneficial impact of regulation on growth
Financial institutions support and foster economic growth by intermediating savings and
allocating them to productive activities.5 These functions are also their inherent sources of
financial fragility. Regulation plays a key role in reducing the scope of financial fragility and
limiting the costs of financial instability. Hence, a well-designed regulatory framework can
actually lead to faster average economic growth over time.
There is vast academic literature that tries to empirically identify the impact of financial
deepening (measured by the ratio of credit to GDP) on long-term economic growth.6 The
precrisis evidence largely pointed to a positive relationship between financial deepening and
long-term economic growth. However, recent evidence has cast doubt on such a simple
monotone relationship. Several studies have shown that at high level of financial
development, the effect of finance on growth becomes negative or insignificant.7 Cecchetti
and Kharroubi (2012)8 put the peak of the effect of credit on GDP growth per worker at a
100% ratio of private credit to GDP. In other words, letting the financial system grow too
much may harm the economy's growth prospects. Correspondingly, regulating finance may
stimulate rather than retard economic development.
Regulation, like any form of public intervention, is justified by the existence of market failures.
Financial regulation is not an exception to this, even though it is somewhat "unique" given the
special role that banks perform in the economy and the high (social) costs associated to the
failure of a financial institution.
Financial regulation is meant to correct financial institutions' incentives toward risk, to induce
them to internalise the costs and the externalities associated to their failures, thus reducing
both the occurrence of crises and the associated costs.
Limiting the occurrence of crises has a positive effect on growth for several reasons. Crises
affect growth asymmetrically: activity falls much more sharply during a crisis than it increases
during credit booms.9 Their negative effect on growth is very long-lasting.10 An empirical
investigation focusing on a large cross section of countries shows that output losses
5
Diamond D., and Dybvig, P. H. (1983), "Bank runs, deposit insurance and liquidity", Journal of Political
Economy, 91, pp. 401-419; Holmstrom, B., and Tirole, J. (1997), "Financial Intermediation, loanable funds
and the real sector", Quarterly Journal of Economics, 112(3), pp. 663-691; Diamond D., (1984), "Financial
intermediation and delegated monitoring", Review of Economic Studies, 51(3), pp. 393-414.
6
It started with Gurley, J. G and Shaw, E.S. (1955) "Financial aspects of economic development" American
Economic Review, 45, pp. 515-538; Goldsmith, R W (1969) Financial Structure and development" Yale
University Press; Shaw, E. (1973): "Financial deepening and economic development", Oxford University
Press, New York, and McKinnon, R.I. (1973) "Money and capital in economic development", Brookings
Institute. More recently, see King R., and R. Levine, (1993), "Finance and growth: Schumpeter might be right",
Quarterly Journal of Economics, 108, pp. 717-737; Rajan, R. and L., Zingales, (1998), "Financial Dependence
and growth", American Economic Review, 88, pp. 559-586; Fisman, R., and I., Love, (2007), "Financial
Dependence and growth revisited", Journal of European Economic Association, 5, pp. 470-479.
7
Cecchetti S. G., and E. Kharroubi, (2012), "Reassessing the impact of finance on growth", BIS Working Paper
381 and Arcand J. L., Berkes E. and Panizza U., (2012) "Too Much Finance?", IMF Working Paper 12/161.
8
Cecchetti S. G., and E. Kharroubi, (2012), "Reassessing the impact of finance on growth", BIS Working
Paper 381.
9
Popov A., (2013), "Credit constraints, equity market liberalization and growth rate asymmetry", Journal of
Development Economics, 107, pp. 202-214; Beckaert G., and Popov A., (2015), "On the kink between the
volatility and the skewness of growth", mimeo.
10
Reinhart C.M., and Rogoff K. S, (2009), "This time is different. Eight centuries of financial follies", Princeton
University Press.
associated with financial crises are highly persistent and may range from 4% to 16%.11 When
the financial sector is in distress, entrepreneurs' access to credit is impaired with negative
effects on the investment of existing firms as well on new business creation.12 Recoveries
from financial crises tend to be slow, 'creditless' and 'jobless'.13 Even if regulation reduces
economic growth in normal times, its impact on average economic growth can still be positive
over time.
But there is a further argument as to why regulation may have a positive effect on growth:
without regulation, the financial sector may become excessively large and displace other,
more productive activities.
Recent growth in the financial system has not necessarily led to more credit availability for
innovative businesses. In the last two decades, banks in developed economies have
channelled an increasing amount of funds to households rather than firms. More and more
savings have flowed into low productivity growth sectors like real estate rather than into
growth enhancing activities such as technology.14 In addition, the growth of the financial
sector and the high remuneration it offers may have drawn talented individuals away from
other productive sectors in the economy since financial and non-financial sectors compete
for the same scarce supply of human capital.15
The need to limit its excessive growth applies not only to the financial system as a whole but
also to individual institutions. I am referring here to the well-known too-big-to-fail problem.
The recent crisis highlighted the risk of letting individual institutions grow excessively. Some
of the recent regulatory changes (Total Loss Absorption Capacity, extra capital charges) can
play a crucial role in solving such a problem, as I will discuss in detail below.
In short, the long-term relationship between finance and growth is complex and non-linear.
But the theory and evidence suggests that effective regulation is likely to be beneficial in the
long run.
What about the short-term impact of regulation? There are good theoretical reasons to
believe that capital ratios' effect on growth should not be overly large. The famous
Modigliani-Miller (MM) 'irrelevance' result16 states that firms' (and banks) business decisions
are independent of their capital structure. Of course, the MM insight is developed in a highly
idealised setting. For example, the tax advantages of debt and the liquidity services
performed by short-term bank liabilities do drive a wedge between the cost of debt and equity
11
Cerra V., and Saxena S. C.,(2008), "Growth dynamics: the myth of economic recovery", American Economic
Review, 98(1), pp. 439-457.
12
Queralto A., (2015), "A model of slow recoveries from financial crises", mimeo.
13
Abiad, A., Dell'Ariccia, G., and B., Li, (2011), "Creditless recoveries", IMF working paper 11/58; Bijsterbosch,
M. and T. Dahlhaus, (2011), "Determinants of credit-less recoveries", ECB working paper 1358; Calvo, G.,
Coricelli, F. and P. Ottonello, (2013), "Jobless recoveries during financial crises: Is inflation on the way out?",
NBER Working Paper 19683.
14
Benigno G., and Fornaro L., (2014), "The financial resource curse", The Scandinavian Journal of Economics,
116 (1), pp. 58-86; Benigno G., Converse N., and Fornaro L., (2015), "Large capital flows, sectoral allocation
and economic performance", Journal of International Money and Finance, forthcoming; Jorda, O., Schularick
M., and Taylor A. M., (2015),"The great mortgaging, crises and business cycle", NBER Working Paper 20501.
15
Philippon, T., (2010), "Financiers versus Engineers: Should the Financial Sector be Taxed or Subsidized?",
American Economic Journal: Macroeconomics, 2(3), pp. 158-182.
16
Modigliani, F. and Miller, M. (1958), The Cost of Capital, Corporation Finance and the Theory of Investment".
American Economic Review 48 (3) pp. 261-297.
for banks. But the empirical papers that have estimated this wedge have found it to be
small.17
Regulators have gone to considerable length to assess the impact of the various regulatory
initiatives. The regular quantitative impact assessments undertaken by the Basel Committee
show that most reporting banks have made significant progress to meet the new regulatory
requirements for capital and liquidity.18 The European Commission has published a
comprehensive study that aims to estimate the joint economic impact of many regulatory
initiatives.19 This study comes to the conclusion that the expected costs of the reforms will be
compensated by the wider economic and societal benefits. Moreover, specific assessments
have been made with regard to the macroeconomic impact of stronger capital, liquidity
requirements and OTC derivative reforms. In the European context, the European Banking
Authority and the Commission have assessed the macroeconomic impact of the regulatory
reform for insurance companies and broadened the assessment with regard to the Liquidity
Coverage Ratio and currently with regard to the Net Stable Funding Ratio.20 Overall, the
evidence available from these studies demonstrates a positive or neutral impact on GDP
growth.
Slow growth in Europe has many structural causes
So what is the cause of slow economic growth if not regulation? GDP growth comes from
three main sources: greater productive efficiency (otherwise known as Total Factor
Productivity or TFP), labour force increases and capital deepening (the increase in the
amount of capital per worker). The contribution of all three factors has been declining over
time and across countries as part of what has been termed 'secular stagnation'.
The main reason why labour force growth has declined is population ageing. As the number
of older retired people grows, the labour force is expected to decline at a rate of around 0.6%
per annum by 2030.21
TFP growth has remained subdued at a rate of expansion of around 1% per annum. The
determinants of TFP growth are not fully understood but among others, Robert Gordon22 has
argued that TFP growth occurs in waves, driven by major innovations. So far, despite its
great promise, the ICT revolution of the 1990s has not led to a pronounced and sustained
pick-up in productivity growth in any of the major industrialised countries.
Finally, the rate of capital deepening (the increase in the amount of capital per worker) has
been weak in recent years reflecting low aggregate demand, financing constraints and weak
business confidence. The contribution of this growth driver is expected to return to more
normal levels as the economic recovery proceeds.
Compared to these structural reasons for the slowdown in growth, the impact of financial
regulation has been modest, at best.
17
Hanson, S. Kashyap, A. and Stein, J. (2011), 'A Macroprudential Approach to Financial Regulation', Journal of
Economic Perspectives 25(1), pp. 5-28, Miles, D. Marcheggiano, G. and Yang, J. (2013), 'Optimal Bank
Capital', Economic Journal, vol. 123(567), pp. 1-37.
18
See BIS/FSB (2010) Assessing the macroeconomic impact of the transition to stronger capital and liquidity
requirements; BIS (2013), Macroeconomic impact assessment of OTC derivatives regulatory reforms.
19
European Commission, Economic review of the financial regulation agenda, May 2014.
20
See DG ECFIN (2007) Impact Assessment: Possible macroeconomic and financial effects of Solvency II and
EBA (2014) Second report on impact assessment for liquidity measures under Article 509 (1) of the CRR.
21
"The Global Economy in 2030: Trends and Strategies for Europe", European Strategy and Policy Analysis
System and Centre for Policy Studies, April 2014.
22
Gordon, R. (2012), "Is US economic growth over? Faltering innovation confronts the six headwinds", NBER
Working Paper 18315.
Another related consequence of secular stagnation may be that the natural real interest rate
(the real interest rate consistent with full employment and stable inflation) has fallen.
Population ageing has shifted the balance between older households who are likely to save
and younger households who are likely to borrow. As a result, real interest rates have
declined substantially in the last two decades.23 Nominal interest rates have also fallen in line
with the real, leaving the 'normal' central bank policy rate much closer to the zero bound,
thus increasing the likelihood of hitting it during deep recessions.
Without getting into a discussion about the merits and risks of unconventional monetary
policy, it is probably fair to say that the zero lower bound on nominal interest rates
complicates the task of monetary policy in trying to stabilise large shocks. Financial crises
are some of the largest peace-time negative shocks to hit market economies and our ability
to use monetary policy in order to deal with them 'ex-post' would be impaired in a secular
stagnation world.
This makes the role of regulation in avoiding financial crises more important than ever. When
it comes to dealing with financial crises, prevention is always better than cure but especially
so when 'mopping-up after the crash' is complicated by the inability to cut short-term interest
rates sufficiently far below zero.24
What has been achieved and what is in the pipeline?
We have seen that, far from damaging growth, a strong regulatory framework is essential in
ensuring strong long-term economic performance. Let me now briefly touch upon the key
achievements of the efforts to reform the financial system.
We have increased capital requirements well above the levels in force before the financial
crisis. This will make banks more resilient to shocks and reduce their incentives to take
excessive risks. We have identified the most systemically important institutions and require
them to have additional capital buffers reflecting the significant externalities their failure
would impose on the financial system and the economy as a whole. The introduction of the
two liquidity ratios will make banks more resilient against sudden liquidity and funding
shocks.
These reforms were changes necessary to the regulatory framework but are, in my view, not
yet sufficient for a stable financial system. In view of the current rhetoric of reform fatigue, it
is important stress that we still need to finalise several important initiatives that are currently
under way. They are all needed in order to effectively correct market failures and with the
minimum of cost to the real economy. TLAC, the leverage ratio and the review of risk weights
would help underpin the effectiveness of capital regulation in avoiding excessive risk-taking
and protecting the real economy from the consequences of bank failure. The attempts to
broaden non-bank funding sources in Europe via improved and safer securitisation practices,
as well as capital markets union, should reduce the negative consequences of bank
deleveraging now as well as in the future.
Total Loss Absorption Capacity Let me begin with the TLAC initiative targeting the most
systemically important banks. Too-big-to-fail is a very important source of market failures and
I consider TLAC as an important element in effectively tackling this distortion. Allow me to
highlight three elements of the proposal.
First of all, the Financial Stability Board (FSB) is right in proposing a global Pillar 1
requirement with the possibility to apply additional Pillar 2 requirements. A pillar 1
requirement delivers a robust international standard for globally systemic important banks
and ensures, at the same time, a global level playing field.
Second, I agree with a Total Loss Absorbency approach with the capital buffers on top.
Having the buffers sit on top of TLAC ensures that they can function as intended, regardless
of the TLAC calibration. Additionally, it allows for a very strict intervention mechanism for
TLAC non-compliance as for the duration of the breach of the buffer requirement, the
automatic distribution restrictions specified in Basel III would apply.
Third, I agree with benchmarking TLAC eligible liabilities against a non-risked weighted
measure (the leverage ratio exposure) in addition to risk-weighted assets. Under the
assumption that TLAC is appropriately calibrated, this ensures that for a failing bank, when
risks have materialised and risk-weights do not matter anymore, the actual loss can be
compensated and the bank successfully recapitalised.
Nevertheless, I acknowledge that industry has raised several important issues to the TLAC
proposal, in particular relating to the size of the required TLAC market, the impact on bank
funding costs, the calibration and the link with the leverage ratio. Let me assure you that we
take these issues seriously. This is why the FSB is performing a thorough impact
assessment in close collaboration with the ECB and other members of the Basel Committee
(BCBS). This assessment includes a shortfall analysis, a market survey to obtain estimates
on investor base and pricing/spread of eligible liabilities, a micro- and macro-economic
impact analysis and a verification of historical losses and recapitalisation - to analyse the
proposed calibration.
Having said this, all regulatory reform, and TLAC in particular, have an impact on the cost of
doing business for banks. And insofar as the increase in funding costs is the result of the
effective removal of the implicit state guarantee this is, in principle, welcome. The benefits of
the removal of the implicit guarantee outweigh the individual increase in costs for society as
a whole. Tax payers and their elected representatives have no appetite for another bail-out.
TLAC will significantly reduce the externalities of a failure of systemically important
institutions that are imposed on the real economy and will therefore have an overall positive
effect on growth.
The Leverage Ratio
The finalisation of the Leverage Ratio (LR) framework should also be a key priority on the
global regulatory reform agenda. Leverage was undoubtedly one of the root causes of the
financial crisis. The 20 largest banks in Europe had built-up significant leverage before the
financial crisis, as their ratios of Book Equity to Total Assets (a reasonable proxy for the new
definition of the Basel Leverage Ratio) had fallen from 6% in the late 1990s to around 3% in
2008.25
Hence, a comprehensive and well-calibrated leverage ratio is an important tool for
addressing such risks that might be circumvented or not captured by the risk-based
framework. I therefore strongly support the migration of the LR to a Pillar 1 requirement, as
foreseen by the Basel Committee. I also see a need to complement the micro-prudential
minimum LR requirement by a macro-prudential LR framework. In particular, further work
should be undertaken on the pros and cons of adding a buffer for systemically important
banks to the LR framework. Large banks contribute most to excessive leverage with their
greater costs of failure and their greater reliance on internal models.
Further work looking at the relationship between the LR and the risk-based framework should
be undertaken. For example, policy makers could consider adding a time-varying buffer.
Such a buffer could help maintain the relative role of the LR in the capital framework once
the countercyclical buffer is activated in the risk-based framework.
There are some concerns about a negative impact of a binding LR requirement on lending to
the real economy. Critics of the LR often argue that it would trigger significant additional
capital requirements and, as a consequence, may make it more costly for banks to finance
the real economy. However, I believe that these concerns are overstated for three reasons.
First, as already mentioned, there are many reasons to believe that the impact of the higher
capital requirements on growth in normal times should not be overly large. In any case, the
latest Basel QIS study shows that the large majority of banks already satisfy the currently
envisaged 3% minimum requirement. Any additional impact would be modest. Second, even
if the LR leads to some contraction in lending, it may still be good for long-run growth if it
helps to avoid costly crises. Finally, there is a more subtle effect by which the LR may
actually help improve lending to the real economy. Recent evidence on risk-weights for SME
lending in Europe26 shows that the average capital cost for this activity in the risk-based
framework is higher than under the LR. This would imply that in a situation where the LR
becomes the binding measure for a subset of banks, banks may potentially increase SME
lending at the expense of other activities, which have a preferential treatment in the
riskbased framework relative to the LR framework. I would encourage further work on this matter
that would present evidence on the significance of this eff