A natural way to gauge the cost of higher capital requirements on banks is to estimate how much lower economic activity – GDP – might be as a result. I want to illustrate the cost of higher capital for banks using a very similar method to that used in the studies mentioned above. The calculation proceeds in steps. First, estimate how much the average interest rate charged by banks would have to increase to recoup any cost of an increase in their equity financing relative to use of debt. Then estimate how much a rise in the cost of borrowing from banks might change the required rate of return (or cost of capital) of investors. Finally use a production function to estimate the impact of such an increase in the cost of capital on desired capital and output. We can then express the cost of having banks hold more equity capital in terms of the present value of all future falls in output. This is the methodology used in the calculations reported in the Bank of England’s 2010 Financial Stability Review (FSR). Those calculations were based on conservative assumptions – understandably so, for fear of under-estimating the cost to the wider economy of imposing substantially higher capital requirements on banks. I will start from that FSR baseline estimate of the present value of output lost as a result of a 1pp increase in the capital ratio, which is 4.25% of current annual GDP.
On the assumption that the three-month Libor rate will remain stable at 0.75% during the next three years, inflation should average 0.7% in 2003, move up to 0.9% in 2004 and reach 1.6% in 2005. Forecast inflation will remain below 1% until the end of 2004 except in the fourth quarter of 2002. In the course of 2005, however, a marked acceleration will set in, with forecast inflation reaching the 2% mark in the fourth quarter of 2005. The new forecast is consistently below that of June 2002. It reflects the delay in the economic upswing. In the new forecast, inflation will rise more markedly at the end of the forecasting horizon due to an even more expansionary monetary policy since June. Expansionary monetary policy to be continued At our last media conference, I pointed out that the National Bank must be prepared to react quickly to changes in the economic situation. When the delay in economic recovery became discernible in summer, we acted immediately by again lowering interest rates. Since then, nothing of basic significance has changed in our assessment of the situation. We shall adhere to our expansionary monetary policy in the foreseeable future. We will thus contribute to the economic rebound and continue to keep Swiss franc investments unattractive. The low interest rate level and the relatively strong growth of monetary aggregates currently do not represent a threat to price stability. Once a sustained economic recovery becomes discernible, we shall have to review our monetary policy and adjust it to the new circumstances.