Chart 7 Banks capital and the break-even impact on probability of financial crises reduction in the probability of a financial crisis per year, %  Baseline  0.9  30% Modigliani-Miller Effect  0.8  Tax offset  0.7  More Substitutes to Bank Finance  0.6 Less Sensitive Investment 0.5 0.4 0.3 0.2 0.1 0 0  1  2  3  4  5  6  7  8  9  10  additional capital as % of banks’ risk-weighted assets  That said, initial increases in banks’ capital will probably have a much more pronounced impact on the likelihood of financial crises than successive increases. For example, a 5 percentage point increase in banks capital from 15% to 20% would likely have considerably less impact on the probability of banks’ failing than raising capital from 10% to 15%. So it is  10  BIS Review 100/2010  important to consider the rate at which the marginal benefits of banks holding more capital will diminish. The June 2010 Financial Stability Report provides illustrative estimates that indicate the benefits of additional capital fall to close to zero once a threshold of around 15% of risk-weighted assets is reached. It is difficult to predict the likely volatility of banks’ assets values and the probability of extreme events that could lead to a financial crisis. A natural starting point is to assume that the shocks hitting the economy and banks’ asset values follow a normal distribution.
About once every 20 years, on average, a shock came along which could be either very good or very bad; it either increased or decreased GDP by around 12%. Much less frequently there came a very much larger – and always negative – hit to GDP. On average this very bad shock came along about once a century; reducing GDP by over 30%. In this type of model first developed by Barro, the shocks to GDP are permanent and so could be expected to affect asset values by comparable magnitudes. So once we allow for rare – but very big – shocks that do not follow a normal distribution then there will be larger benefits from banks having much more capital. And without allowing for such shocks it is not possible to explain the historical variability of economic activity across countries. In summary, even taking a conservative view of the cost of extra bank capital the net benefits of stricter capital requirements are potentially large. But relaxing these conservative assumptions implies the costs of higher capital requirements are likely to be much lower. Furthermore, the benefits of capital requirements are likely to be considerable, especially if one does not assume that the shocks to economic output and banks’ asset values follow a normal distribution. 12  See for example “Rare Disasters and Asset Markets in the Twentieth Century” by Robert Barro, Quarterly Journal of Economics, 2006, 121, no. 3.