3  See Barrell, R, Davis, E, Fic, T, Holland, D, Kirby, S, and Liadze, I (2009), “Optimal regulation of bank capital and liquidity: how to calibrate new international standards”, FSA Occasional Paper 38. The paper indicates that a 1% rise in capital requirements could reduce output by 0.08% of GDP in the long run. Discounted at a rate of 3% this would imply a 2.7% reduction in current GDP. BIS Review 100/2010  5  GDP in present value terms, though it also finds that the GDP benefits from increasing capital requirements from their current level substantially outweigh these costs 4. The NIESR and FSR estimates look much lower than the IIF figure. But the IIF estimate is for the impact of a range of adjustments which include a more than 1% rise in bank capital. Nonetheless that estimate looks likely to be higher than the illustrative calculation in the FSR. But rather than seeing the FSR calculations as generating a very low estimate of the cost of higher capital requirements, I think they are more likely to be a conservative assessment that reflects the care taken not to underestimate the cost of higher bank capital. The costs of extra bank capital Many assessments from commentators and practitioners, though often not precisely quantified, suggest that the costs of significantly higher capital requirements for banks are very substantial.
I am rather sceptical about the claims that substantially higher capital requirements must mean significantly higher costs of funds for those who borrow to invest and that total investment and output in the economy will be significantly lower. There are two reasons for my scepticism. First, a simple historical point. In the UK and in the USA economic performance was not obviously far worse when banks held very much higher levels of capital. Investment – relative to GDP – was not lower. This is prime facie evidence that much higher levels of bank capital do not cripple development, and the financing of investment. Conversely, there is little evidence that investment or the average (or potential) growth rate of the UK economy picked up as spreads on bank lending narrowed over the past decade, and the volume of bank credit expanded sharply (Chart 5). Chart 5 UK GDP growth GDP Growth  10 Year Rolling Average  % 8 6 4 2 0 -2 -4 -6  1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005  Source: Bank of England, Monetary and Financial Statistics. Second, the most straightforward and logically consistent model of the overall impact of higher equity capital (and less debt) on the total cost of finance of a company implies that the effect is zero. The Modigliani Miller (MM) theorem implies that as more equity capital is  4  See Box 7 in chapter 5 of Bank of England, Financial Stability Report, June 2010.