Variable Capital Rules in a Risky World

Òscar Jordà of the Federal Reserve Bank of San Francisco writes this nice piece.

By capital rules he means the capital banks are supposed to hold. There are multiple capital rules floating around, which one to choose?

Equity is the levee that protects a bank from a flood of bad loans. Not surprisingly, the Basel Committee on Bank Supervision concluded in 2010 that the best protection against another financial crisis is to increase the quantity and quality of capital banks are required to hold. This is the microprudential component of Basel III, as this new regulatory framework is known. But Basel III also introduces a novel piece of macroprudential regulation called countercyclical buffers. Under this mechanism, banks would accumulate capital in periods of unusually high credit growth, thus slowing the formation of credit bubbles, strengthening bank balance sheets, and preventing draw-down spirals. These can occur when a bank responds to a series of write-downs by slowing loan growth to protect its capital position, thereby triggering a domino effect on credit availability.

Basel III stipulates that countercyclical buffers be capital ratios of 0 to 2.5% on top of a 7% core capital requirement. It leaves implementation to national regulators. In June, in a move to further buttress the macroprudential edifice, a requirement was added that international systemically important financial institutions (SIFIs) hold an extra 1–2.5% in equity. In the United States, the Dodd-Frank Wall Street Reform and Consumer Protection Act requires that the Federal Reserve establish special prudential standards for domestic SIFIs. In a recent speech, Governor Tarullo (2011) suggested that SIFI capital requirements could be as high as 14%. That would mean 2% above the 7% core capital requirement, the 2.5% upper limit of the countercyclical buffer, and the 2.5% Basel III requirement for global SIFIs. Bankers warn that such increases could be a death knell for economic growth. Assessing this claim requires a look at the history of finance since the 1870s.

He points that increases in credit growth since 1970s has not really led to any benefits. So to say higher capital wopuld choke credit and then growth is not really  right:

history illustrates the regulatory dilemma of balancing financial stability and stable economic growth. Strict regulation can choke off access to credit, douse entrepreneurial initiative, and disturb the channels by which risk is shared. Yet, average output growth from 1945 to 1975 in the 14 countries was double the rate of the period since then. And economic activity has become more volatile. Hume and Sentance (2009) have pointed out that aggregate investment has stagnated or fallen despite the sharp rise in outstanding credit volumes. Turner (2011) concludes, “There is no clear evidence that the growth in the rate and complexity of the financial system in the rich developed world over the last 20 to 30 years has driven increased growth stability.”


He says the problem in designing these countercyclical capital regulations is to determine when the financial instability is increasing. For this, best bet is to look at credit trends. When credit growth start to rise from the normal trend, time to kick in these capital requirements:

In several papers, trend deviations of credit from GDP have been identified as reasonable indicators of impending financial mishaps (Jordà et al. 2011, Repullo and Saurina 2011, and Schularick and Taylor 2011). A regulator may compare measures of credit deviation with a specified threshold. Above the threshold, the countercyclical buffer is stocked to avert a financial crisis. Below it, the buffer is tapped to restore financial calm. If the costs of regulation are low relative to the losses experienced in a financial crisis, taking into account the infrequency with which crises occur, a low, conservative threshold might be appropriate. A low threshold may generate numerous false positives, but costly crises will almost certainly be averted. On the other hand, if the costs of regulation are high relative to the consequences of a financial catastrophe, then higher thresholds should be chosen. Crises will sometimes be missed, but their costs will be offset by keeping capital buffers low most of the time.

So till we have some more accurate measures, focus on credit growth…


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