BIS central bankers’ speeches  5  England’s regional agents suggest that the supply of loans on offer has increased, but businesses are understandably cautious on the take up. Looking at the broader picture, the post-crisis adjustment of the capital adequacy standard is a welcome and necessary correction of the excessively lax underwriting and pricing of risk which caused the build up of fragility in the banking system and led to the crisis. I do not however accept the view that raising capital standards damages lending. There are few, if any, banks that have been weakened as a result of raising capital. Analysis by the Bank for International Settlements indicates that in the post crisis period banks with higher capital ratios have experienced higher asset and loan growth5. Other work by the BIS also shows a positive relationship between bank capitalisation and lending growth, and that the impact of higher capital levels on lending may be especially significant during a stress period6. IMF analysis indicates that banks with stronger core capital are less likely to reduce certain types of lending when impacted by an adverse funding shock7. And our own analysis indicates that banks with larger capital buffers tend to reduce lending less when faced with an increase in capital requirements. These banks are less likely to cut lending aggressively in response to a shock8. These empirical results are intuitive and accord with our supervisory experience, namely that a weakly capitalised bank is not in a position to expand its lending.
The FPC will shortly be consulting on the scope and form of its application, and that will be a welcome debate. Getting the incentives right for banks in terms of the capital adequacy regime is hugely important. The leverage ratio is simple and that is its appeal, but on its own it could encourage banks to take more risk per unit of assets. In contrast, internal models and stress tests are complicated, and therefore carry the risk of opacity and model error. There is now a growing debate on the use of models and stress tests. In many respects, the debate has common ground, since models are intrinsic to stress tests. My view is that this is not a debate about whether or not supervisors should use models. That question was answered a long time ago in the reasoning for the switch away from Basel I. The design and implementation of Basel II was not done well, and a substantial charge has been required. A major lesson is that to use models and stress tests effectively requires intensive development and maintenance by firms and a highly skilled body of supervisors and a regime where judgement can be used. It also requires the supervisor to have a credible capacity to withdraw the permission given to a firm to use a particular model if the model is considered to be inadequate or the firm has not demonstrated the capacity to use it safely.