Lending to nonfinancial corporates will see a material impact from Basel III.
New research on the effects of higher variable bank capital requirements indicates that lending to nonfinancial corporates will be materially impacted, although not as much as lending to the commercial real estate sector.
The Bank of England working paper (“The impact of capital requirements on bank lending”) by Jonathan Bridges, David Gregory, Mette Nielsen, Silvia Pezzini, Amar Radia and Marco Spaltro, examines a new data set that reflects changing bank capital requirements in the UK from 1990 to 2011. The authors regressed this data against individual banks’ credit provision to a variety of industry sectors.
The research yields two results. First, not unsurprisingly, banks rebuild their economic capital – the amount they hold above regulatory minimums – gradually. Second, the higher capital requirements spur banks to cut lending to different sectors within the first year, most dramatically to commercial real estate, then to nonfinancial corporates, and finally to households. Loan growth recovers over the course of three years, the authors report.
The research can inform corporate treasurers of what to expect as the Basel III capital requirements and leverage ratios are implemented between now and 2019. The results provide more granularity to an OECD study conducted in early 2011 (“Macroeconomic Impact of Basel III”), which estimated that the medium-term impact of Basel III implementation on GDP growth would be in the range of -5 basis points to -15 basis points per annum. To meet their capital requirements in 2015, the OECD estimated that banks would increase their lending spreads by about 15 basis points. To meet the requirements that kick in by 2019, banks will increase their spreads by about 50 basis points, the OECD report stated (see table below, Source: OECD).
The Bank of England researchers determined that following a one percentage point permanent increase in capital requirements, a typical bank will increase its capital ratio to restore its capital buffer (that is, what it holds above regulatory minimums) by 0.4 percentage points after one year, by 0.9 after 3 years, and broadly one-for-one in the long run.
Credit Contraction
This correlates with a reduction in corporate lending, especially to the commercial real estate sector. Faced with a 1 percentage point increase in capital requirements, banks reduce commercial real estate loan growth by around 4 percentage points after one quarter. Loan growth to private non-financial corporations in other industries also falls following an increase in capital requirements, albeit by less than for commercial real estate companies – quarterly loan growth falls by 2.1 percentage points in the first quarter.
The Bank of England research is notable in that it is based on actual, granular observed behavior, rather than estimates. The BIS’s Quantitative Impact Surveys and subsequent research relied on a broad number of assumptions when estimating the economic impact of the Basel III accord.
For example, in early 2012 BIS researchers published a paper (“The Impact of Strengthened Basel III Banking Regulation on Lending Spreads”) looking at different industries and countries from 2005-2010. It assumed that banks would attempt to defend their returns on equity by reducing long-term liabilities. (This has, in fact happened quite dramatically in recent years, leading to a sharp drop in fixed income liquidity.) Nonetheless, the BIS found, “The required lending spreads to keep ROE from falling vary from by 0.1 basis point for real estate & mortgage banks to 9.1 basis points for commercial banks over the entire sample periods.”
The BIS paper found that the increase in lending spreads is sensitive to the ratio of risk-weighted assets and loans to total assets. The ratio of risk-weight assets to the total assets determines the amount of equity to be raised in order to satisfy the capital regulation, thereby determining the amount of long term debt reduced which affects the net income of the banks.
The BIS researchers also noted significant differences among countries: “Countries such as Brazil, China, India, and Mexico require the banks to have large lending spreads ranging from 13.2 basis points to 29.7 basis points. On the other hand, countries such as Australia, Switzerland, Germany, Italy, and Netherland require them to increase smaller lending spreads for the increase in the regulatory capital.”
Another Coffin Nail
The Bank of England research is another nail in the coffin for the Modigliani-Miller theorem, which holds that the composition of a bank’s liabilities should not affect its funding costs. As the authors write, “Without a change in funding costs, there is no reason why a change in the capital ratio of a bank, ceteris paribus, should impact on the price or quantity of credit.”
The usual caveats apply – the theorem is undermined by various frictions such as the tax deductibility of interest payments, asymmetric information and so on. These may cause changes in capital requirements to manifest themselves in the cost and availability of credit.
Treasurers considering their options in this evolving market structure might plan to move from bank credit to the bond markets, or other types of short-term funding such as ABCP. But the increase in capital requirements are forcing banks to unload bond inventories and run lean with inventory, and the lines they extend to ABCP vehicles will suffer from the same cost considerations affecting direct loans. It may be that there are no ways to obtain credit as cheaply as in the past.