If capital requirements are increased significantly, but only on some activities, banks may re-classify assets to switch their business into forms where the capital requirements are no higher than today. To me that is an argument for thinking about very substantial rises in required bank capital pretty much across the full range of their activities. Of course if this is very costly it will create two problems: it would create big incentives to avoid them and potentially big costs to the wider economy, because of the impact on the price and availability of bank loans. Two issues are important. First, the scale of the impact on bank funding costs from higher capital requirements. Higher funding costs would push up on the cost of bank loans to households and non-financial companies and affect lending and investment, which in turn could require a monetary policy response; those costs will also affect the incentives to avoid (or evade) capital requirements. The second issue is how much more robust the financial sector, and banks in particular, become with different amounts of extra capital. Several estimates of the cost of higher bank capital exist. The Institute for International Finance (IIF) suggest that proposed regulatory reform which could be part of the Basle III system could reduce the path of average annual GDP growth in the US, euro area and Japan by 0.3pp for the next ten years 2. This implies that the level of GDP would ultimately be around 3% lower.
If we assume that financial crises would otherwise occur once in every 25 years (an annual frequency of 4%) then a rise in banks capital by 10 of riskweighted assets would be justified if it reduced the probability of financial crises so that they occurred with an annual probability of 3.2%, or once every 31 years. Alternatively, taking the most favourable assumptions on cost (full tax offsets, partial Modigliani Miller offsets, a lower use of bank debt and lower sensitivity of investment spending) the blue line indicates a 10% rise in capital relative to assets would be justified if it reduced the probability of financial crises from 4% a year to 3.9%, or from once every 25 years to once every 25.4 years. (The final column in the table shows that calculation for each case). Such a small decline in the likelihood of a financial crisis would not appear to be overly ambitious for such a sharp rise in the capital ratio. For typical banks the capital ratio starts out from a level under 10%, so that a rise in capital of 10% of risk assets is more than a doubling in the amount of bank capital.