The Hidden Costs of Simplicity: Standardized Capital Requirements Erode Lending Incentives

19 Jul 2019
Read Time 5 mins
Categories :
Bank Capital

Introduction

All banks need capital to remain robust and resilient.  Indeed, over the past 10 years, the amount of capital maintained by Financial Services Forum members has increased dramatically from $650 billion to over $925 billion.  And while capital is often viewed in terms of its effect on a bank’s resilience, it is also important to understand how capital requirements affect the incentives to engage in lending, which is essential to a healthy economy. 

In this post, we discuss the differences between standardized and risk-based capital requirements, review recent trends in the two capital requirements, and discuss how these trends are affecting bank incentives to lend and support the economy.

 

Capital, Debt and the Cost of Lending

Banks fund all of their lending from two sources: equity and debt.  Equity capital refers to shares of equity issued by the bank to outside investors.  Equity owners share in the earnings of a bank through dividends and also share in any losses that result when bank loans are not repaid.  Debt refers to money that has been borrowed by banks from the public in the form of deposits or bonds.  Debt holders are entitled to receive the funds they have lent the bank before equity holders receive any payment.  Accordingly, equity holders bear more risk than debt holders and expect a greater rate of return on their invested funds.  As a general rule, the rate of return on equity in the U.S. has hovered around 10 percent while deposits and bonds issued by banks pay substantially lower interest rates – in the neighborhood of one to five percent.  Since equity holders demand a greater rate of return than debt holders, equity is more expensive than debt and a loan that is funded with more equity is more expensive.  As the cost of making a loan rises, banks have an incentive to either pass on those costs to borrowers or make fewer loans.

A bank considers the riskiness of the borrower when determining how much equity should be used to fund a loan. A loan made to a less risky borrower who is less likely to default is safer and can be prudently funded with less equity and more debt.  Accordingly, the riskiness of the borrower has a direct impact on the interest rate that must be paid on a loan.  A loan made to a low-risk, creditworthy borrower will typically carry a lower interest rate because it can be funded with less equity and more debt.  Anyone who uses a credit card, or has taken out an auto or home mortgage loan understands this principle.  Borrowers with good credit and a strong repayment history are generally offered better loan rates.  That is a sensible policy that links credit risk directly to the cost of a loan.

 

Risk-Based and Standardized Bank Capital Requirements

Bank regulators require banks to calculate their capital requirements in two ways.  First, banks calculate the risk of a loan using their internal assessment of credit risk based on a variety of risk factors such as a borrower’s repayment history, level of earnings, or underlying business prospects.  The second way is to use a standardized method that is prescribed by regulators. These standardized methods are either completely blind to risk or only consider a small number of risk factors.  A bank must then measure its capital against whichever method results in a greater estimate of risk and higher capital.  As an example, consider a bank with a capital requirement of 10 percent.  Suppose that that the standardized approach assumes that the risk of a $100 corporate loan requires $10 in equity capital (i.e. 10% x $100=$10).  Suppose further that the bank has assessed the risk of the company in question and has determined that the company is only half as risky as a typical corporate borrower because it has a strong business model and a long history of timely loan payments, so that only $5 in equity capital is needed.  Under the current capital rules, the bank would be required to maintain $10 in capital against the corporate loan.

When standardized capital requirements exceed risk-based capital requirements for loans, banks are required to fund these loans with more equity, which increases their cost.  Moreover, since standardized requirements typically do not vary with risk, these requirements tend to be larger than risk-based requirements.  These increased costs are then either passed on to borrowers in terms of higher interest rates, or banks make fewer loans and invest in other assets, such as corporate securities with less punitive capital requirements.  Moreover, standardized, one-size, fits-all capital requirements make it more difficult for banks to reward low-risk borrowers with lower interest rates. 

 

The Rise of Standardized Capital Requirements

The tension between standardized and risk-based capital requirements is becoming more and more important because standardized capital requirements have increased substantially relative to risk-based requirements in recent years.  The increase over the past several years has multiple causes, but one important driver is a set of changes to standardized capital requirements that was enacted under Basel III in 2013 that made standardized requirements significantly less risk-sensitive and more punitive.  As a specific example, under Basel III, all corporate loans receive the same standardized capital requirement regardless of risk.  The new standardized requirement is consistent with the requirement that would be prudent for a high-risk borrower, which increases the overall capital requirements for corporate loans and makes it difficult to recognize low-risk corporate borrowers.

Figure 1 shows risk-based and standardized risk-weighted assets – which directly relate to capital requirements –for each Forum member between 2016:Q1 and 2019:Q1.  As shown in the Figure, for a number of Forum members, the gap between standardized and risk-based requirements has closed considerably – see for example JPMorgan Chase, Bank of America and Citigroup – and in the case of every Forum member except BNY Mellon and Goldman Sachs, standardized capital requirements now exceed risk-based requirements.

Figure 1: Forum Member Standardized vs. Advanced Approach Capital

Source: Federal Reserve Y-9C

This trend in standardized and risk-based requirements is troubling because of its effect on the incentives for banks to provide credit to the real economy.  When capital requirements are determined by standardized methods that do not reflect risk, banks are less able to reward less-risky borrowers and have an incentive to reduce lending altogether.  Essentially, the dominance of standardized capital requirements “paints all borrowers with the same brush” in a way that ignores important variation in risk and raises costs. 

And it is important to recognize that this concern is not academic.  The constraining nature of risk-insensitive, standardized capital requirements are having an impact on real lending decisions that affect the U.S. economy.  As a specific example, JPMorgan Chase recently disclosed at its 2019 Investor Day conference how standardized capital requirements make corporate lending more costly, and as a result, more challenging to grow in the future.  Since capital requirements for corporate loans do not vary with risk under the standardized approach, banks generally have a weaker incentive to lend to low-risk borrowers.

Conclusion

The primary business of banking is assessing risk.  Banks make lending decisions and allocate credit based on their assessment of risk.  Banks also want to attract lower-risk borrowers by offering them better lending rates.  When bank capital is determined by risk-insensitive, standardized methods, banks are unable to allocate credit effectively, the cost of extending loans increases, and the economic incentive to lend is blunted.  Recently, standardized capital requirements have begun to place a more significant constraint on bank lending decisions, a development that ultimately impacts the whole economy.  Regulators should strive to ensure that banks have robust levels of capital, but should also support capital requirements that are risk-based to promote an efficient allocation of credit to support overall economic growth.          

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