Economic Consequences of Higher
Regulatory Capital for Banks
By VK Sharma
Former Executive Director
Reserve Bank of India
Pre- crisis , luxuriant supply of liquidity in an exceptionally low interest rate environment led banks any which way to expand credit and inflate in the bargain the now infamous credit bubble with all its cataclysmic consequences. All through the inflating of this bubble, banks actively engaged in excessively leveraging their balance sheets with no questions asked by regulators ostensibly beacuse banks were all this while fully Basel 2 compliant based on their risk weighted assets ! And one very compelling reason for this was banks looking for ways to pay excessively high executive compensation . This ,for a given NIM ( net interest margin) and a given level of borrowing costs,, resulted in ever increasing compression of RoA ( Return on assets) parameter which, in turn, left no choice for banks but to correspondingly increase leverage with a view to keeping shareholders happy by delivering market competitive equilibrium ROE ( Return on equity) to a point where hedge funds,traditionally considered byword for leverage , came to look like apostles of defensive strategy in comparision ! So, if anything , the worst financial disaster, bordering on a veritable global financial and economic nuclear winter, happened , not in spite, but because , of Basel 2 !!
After the fact, regulators became wiser and thought up Basel 3 which mandates a minimum leverage ratio of 3% or a maximum leverage of 33 times ! Given that even this 3% is rather low, one can imagine where banks were on this parameter before the cataclysm ! And no less, even this rather modest number seems very ambitious if one reckons with the fact that even this has to be complied with only by March 2018 ! But significantly, this is a redeeming feature because any quicker transition would be counterproductive for the real economy given the state in which it currently is .
To have a sense of what a quicker transition could mean for the real economy , it is instructive, intuitively appealing and insightful to model changes in output/growth in the real economy through an analogy of ICOR ( incremental capital to output ratio) by conceptualizing IAOR (incremental assets to output ratio) ! Any quicker increase in regulatory capital will, as it already has, result in deleveraging or shrinking of,or no growth in, bank balance sheets hurting output and jobs . Specifically, the IAOR for India is empirically estimated at 2.5 which means that for 1% decline in bank assets, output will decline by 0.4 % ! This then is the powerful and intuitively compelling way to model the impact of an increase in the regulatory capital or lverage ratio for banks on the real economy and explains the caution on the part of regulators in calibrating the phasing in of higher regulatory capital and leverage ratio.
The other way higher regulatory capital and leverage ratio will hurt growth/output/jobs is through Taylor Rule. In this formulation, higher regulatory capital or leverage ratio would mean involuntary monetary tightening as it were ! This would happen because all else being equal, which means NIM-RoA also remaining unchanged, RoA would need to rise for banks to be able to continue to deliver market competitive equilibrium return on equity (RoE) to attract equity capital . With no further cost cutting and efficiency gains immediately possible, this, in turn, will, through corresponding increase in NIM, increase borrowing costs for the real economy the effect of which would be the same as that of involuntary monetary tightening. It is precisely to mitigate this adverse impact on growth/output/jobs that calibrated transition to higher regulatory capital/leverage ratio has been envisaged although 3% leverage ratio itself is rather low and needs to be higher at around 5 % to 7% ! Indeed, Indian banks are already here and therefore already 2.5 times Basel 3 compliant ! Of course , the upside of longer transition would be that inspite of inreasing RoA, banks may even succeed over time in reducing , or even minimizing , NIM-RoA via endogenous business process re engineering and technology upgradation, resulting in reduced borrowing costs for the real economy !
Incidentally, but significantly, Indian banks being already 2.5 times Basel 3 compliant with leverage ratio of 7% plus will need to increase equity capital only to maintain their existing leverage ratio i.e to remain compliant with themselves and not at all to comply with Basel 3 as is widely,but erroneously, made out in many quarters ! This conclusion will very much be valid even if the denominator of the leverage ratio is inflated to include all off balance sheet liabilities which in the case of Indian banks are about 100% of the aggregate assets because this will only reduce the leverage ratio from 7%+ to 3.5%+ which is still higher than Basel 3 requirement of 3% !!
___________________________ ________________________
Regulatory Capital for Banks
By VK Sharma
Former Executive Director
Reserve Bank of India
Pre- crisis , luxuriant supply of liquidity in an exceptionally low interest rate environment led banks any which way to expand credit and inflate in the bargain the now infamous credit bubble with all its cataclysmic consequences. All through the inflating of this bubble, banks actively engaged in excessively leveraging their balance sheets with no questions asked by regulators ostensibly beacuse banks were all this while fully Basel 2 compliant based on their risk weighted assets ! And one very compelling reason for this was banks looking for ways to pay excessively high executive compensation . This ,for a given NIM ( net interest margin) and a given level of borrowing costs,, resulted in ever increasing compression of RoA ( Return on assets) parameter which, in turn, left no choice for banks but to correspondingly increase leverage with a view to keeping shareholders happy by delivering market competitive equilibrium ROE ( Return on equity) to a point where hedge funds,traditionally considered byword for leverage , came to look like apostles of defensive strategy in comparision ! So, if anything , the worst financial disaster, bordering on a veritable global financial and economic nuclear winter, happened , not in spite, but because , of Basel 2 !!
After the fact, regulators became wiser and thought up Basel 3 which mandates a minimum leverage ratio of 3% or a maximum leverage of 33 times ! Given that even this 3% is rather low, one can imagine where banks were on this parameter before the cataclysm ! And no less, even this rather modest number seems very ambitious if one reckons with the fact that even this has to be complied with only by March 2018 ! But significantly, this is a redeeming feature because any quicker transition would be counterproductive for the real economy given the state in which it currently is .
To have a sense of what a quicker transition could mean for the real economy , it is instructive, intuitively appealing and insightful to model changes in output/growth in the real economy through an analogy of ICOR ( incremental capital to output ratio) by conceptualizing IAOR (incremental assets to output ratio) ! Any quicker increase in regulatory capital will, as it already has, result in deleveraging or shrinking of,or no growth in, bank balance sheets hurting output and jobs . Specifically, the IAOR for India is empirically estimated at 2.5 which means that for 1% decline in bank assets, output will decline by 0.4 % ! This then is the powerful and intuitively compelling way to model the impact of an increase in the regulatory capital or lverage ratio for banks on the real economy and explains the caution on the part of regulators in calibrating the phasing in of higher regulatory capital and leverage ratio.
The other way higher regulatory capital and leverage ratio will hurt growth/output/jobs is through Taylor Rule. In this formulation, higher regulatory capital or leverage ratio would mean involuntary monetary tightening as it were ! This would happen because all else being equal, which means NIM-RoA also remaining unchanged, RoA would need to rise for banks to be able to continue to deliver market competitive equilibrium return on equity (RoE) to attract equity capital . With no further cost cutting and efficiency gains immediately possible, this, in turn, will, through corresponding increase in NIM, increase borrowing costs for the real economy the effect of which would be the same as that of involuntary monetary tightening. It is precisely to mitigate this adverse impact on growth/output/jobs that calibrated transition to higher regulatory capital/leverage ratio has been envisaged although 3% leverage ratio itself is rather low and needs to be higher at around 5 % to 7% ! Indeed, Indian banks are already here and therefore already 2.5 times Basel 3 compliant ! Of course , the upside of longer transition would be that inspite of inreasing RoA, banks may even succeed over time in reducing , or even minimizing , NIM-RoA via endogenous business process re engineering and technology upgradation, resulting in reduced borrowing costs for the real economy !
Incidentally, but significantly, Indian banks being already 2.5 times Basel 3 compliant with leverage ratio of 7% plus will need to increase equity capital only to maintain their existing leverage ratio i.e to remain compliant with themselves and not at all to comply with Basel 3 as is widely,but erroneously, made out in many quarters ! This conclusion will very much be valid even if the denominator of the leverage ratio is inflated to include all off balance sheet liabilities which in the case of Indian banks are about 100% of the aggregate assets because this will only reduce the leverage ratio from 7%+ to 3.5%+ which is still higher than Basel 3 requirement of 3% !!
___________________________ ________________________
No comments:
Post a Comment