The statistician W. Edwards Deming once famously said, “In God we trust; all others bring data.” He might well have been talking about bank regulations. Repeatedly, there are industry-supported efforts to roll back bank regulation claiming that these rules “kill lending.” This theme has resurfaced due to the recent proposal by U.S. bank regulators to update Basel III rules, what the media and bank industry are referring to as the “Basel III Endgame.” Assertions need to be backed up by data. As I mentioned in this week’s hearing on bank regulations, Dodd-Frank and Basel III regulations in the U.S. have not slowed down banks’ lending, asset growth, earnings, dividend payouts, share buybacks, or their political contributions to legislators.
Hearing: A Holistic Review of Regulators: Regulatory Overreach and Economic Consequences
At this week’s hearing on bank regulations, legislators demonstrated significant interest in whether the proposal on updating Basel III rules would hurt bank lending, especially to small-medium sized companies. Several Republicans asked one of the witnesses, Emeritus Professor Hal Scott, whether the new proposed U.S. Basel III rules would lead to reduced lending. He responded several times ‘yes’ and referred to his written testimony on page 6 where he wrote “a 2016 report by the Bank for International Settlements (“BIS”) summarized this extensive body of literature as indicating that for every one percentage point increase in capital ratios, banks tend to cut their lending in the long run by 1.4–3.5%.” There are several problems with this quote and how it is now being used by some legislators. The Basel Committee on Banking Supervision 2016 working paper entitled “Literature Review on Integration of Regulatory Capital and Liquidity Instruments surveyed studies conducted overwhelmingly in periods when Basel III was not even in effect. Obviously, these studies were not about the proposed U.S. Basel III rules that were just released on July 2023. Basel III was finalized in 2010 and implementation in most countries started in 2012. With the exception of two study in the literature review, all the other ones covered periods before 2011. Hence those studies do not cover how capital increases in Basel III from Basel II impacted lending. Additionally, the vast number of the studies in the review are of banks in the U.K. and Europe. There is no indication that the researchers of those studies covered U.S. banks at all.
Scott did not mention that the literature review stated that “A key aim of capital requirements is to increase banks’ resilience to future shocks. Capital requirements enhance financial stability by reducing banks’ incentives to take on excessive risks ex ante, and by making banks more able to absorb losses ex post. However, banks may also respond to higher capital requirements by increasing lending rates or reducing credit, which, in turn, may slowdown economic growth or, even worse, deepen an economic recession.” Banks may choose to increase lending rates or reduce credit, but they do not have to. As I stated in my oral testimony, “Large banks can meet the updated capital and bank resolution requirements. In addition to issuing equity and subordinated debt and reducing dividend payouts and share buybacks, banks have myriads of other tools to lower their risk-weights, known as risk optimization.[1] Examples of such tools include improving data quality to more accurately calculate risks. Banks can reduce holdings of tailored derivatives and illiquid alternative investments. Other risk mitigation techniques include selling loans into special purpose vehicles and using credit derivatives to reduce risk weights.”
Academic Studies
In my written testimony for the hearing, I wrote that the Basel Committee on Banking Supervision analysis published in 2022 showed greater improvements for banks globally that were more heavily impacted by the Basel III reforms, “suggesting that the reforms were an important driver of this increased resilience. Greater resilience did not come at the expense of banks’ cost of capital, as banks more heavily impacted by the reforms also saw a greater decrease in their cost of capital. There is no robust evidence and only some indication that banks with lower initial [Common Equity] CET1 ratios and [Liquidity Coverage Ratio] LCRs had lower loan growth than their peers. As the overall intent of the reforms has been to strengthen the banking system and mitigate contagion to other parts of the financial system, the report also analyses market-based systemic risk measures, which showed improvement following implementation of the reforms.”
Globally, bank lending grew in aggregate after the Basel III reforms both for banks above the initial median of a given regulatory ratio and banks below the initial median of that regulatory ratio, for each of the four regulatory ratios that the Basel Committee analyzed.
In 2020, World Bank researchers found that bank “capital can help banks smooth the supply of credit during crisis years. In times of economic turmoil, banks with larger capital buffers are somewhat protected from cuts in lending.” In fact, countries with better capitalized banking systems in 2006, prior to the start of the financial crisis, experienced higher lending growth during and after the crisis. According to Professors Stephen G. Cecchetti and Kermit L. Schoenholtz, “higher capital did not slow the economy. Second, we reported on research at the BIS establishing that better capitalized banks experience lower funding costs, higher growth of debt funding, and higher growth of lending volumes.”
Importantly, when banks are better capitalized, their probability of default declines. This leads to a decline in banks’ borrowing costs. Credit rating agencies, lenders, and bond investors react favorably when banks’ credit quality is higher. As Professor Juliane Begenau points out in her research, the reduction in cost of borrowing allows banks to continue lending and in fact can allow them to lend more than when their credit quality was poorer. The Federal Reserve Bank of Philadelphia’s research has also found that better-capitalized banks create more funding liquidity and lend more even during times when cash deposit balances are falling.
Banks that perform poorly on stress tests because they are not well capitalized, tend to reduce lending. Yet, “those banks may not increase the supply of loans that perform well under the stress test. This portfolio rebalancing thus can lead to an overall reduction of credit supply relative to banks that don’t experience large stress-test losses.”
Basel III and Small-Medium Enterprises
Additionally, in 2019 the Financial Stability Board found that Basel III rules had not hurt lending to small-medium enterprises in the Basel Committee jurisdictions. In fact, what impacts small businesses adversely are often poor due diligence and underwriting processes at banks. According to an analysis conducted by Moody’s Analytics, “although small business loans constitute more than a quarter of the lending volume in the US, most banks do not have effective systems and practices to accurately and efficiently assess small business risk and seamlessly conduct lending activities.” Importantly, Moody’s Analytics research also found that “small businesses also face a unique set of challenges that make the process of getting credit difficult, including:
- Lack of knowledge of their credit risk and how they can improve their business credit standing.
- Opacity of banks’ credit assessment process and expectations.
- Inconsistent requirements among banks in terms of the lending process, necessary data, and documentation.
- Difficulty in maintaining current and accurate financial reporting due to manual processes and lack of expertise.
Bank regulations do not need to lead to a reduction in loans to credit worthy individuals and companies of all sizes to meet capital ratios. A capital ratio is comprised of a numerator and a denominator. Banks can increase the numerator, that is, they can issue more equity and loss absorbing debt issuance. Banks can also increase the numerator by increasing their retained earnings and reducing dividend payouts and share buybacks. To reduce the denominator, banks can reduce risks, referred to as risk-weight optimization. For example, banks can reduce holdings of riskier assets such as poor credit quality loans, below investment grade bonds, securitizations, and derivatives that consume more capital. Moreover, they can use credit and interest rate derivatives to mitigate risks in their loans, securities, or derivatives assets, which in turn reduces their risk weights helping them meet capital requirements.
U.S. Banks Since 2010
U.S. Bank Failures
Since start of Basel III and Dodd-Frank Before Basel III and Dodd-Frank
As of mid-September 2023, globally systemically important banks and large regional banks in the U.S. have a credit rating, ranging from A – AA-. This is in spite of the rise in Dodd-Frank and Basel III requirements in the last decade. The banks that are rated in the A range are considered of high credit quality with “a strong capacity for timely payment of financial commitments which may be more vulnerable to changes in circumstances/economic conditions.” The banks in the AA range are considered to be a very high credit quality with a “very strong capacity for timely payment of financial commitments which is not significantly vulnerable to foreseeable events.”
Data relevant to the U.S. shows that banks’ assets and profit have grown significantly during periods of additional capital, liquidity, and leverage requirements. Since 2010, when Basel III and Dodd-Frank rules started being implemented incrementally, U.S. banking assets have almost doubled. U.S. banks’ net income has risen by 225%.
Publicly traded banks have increased dividend payouts to record highs. And banks’ contributions to political campaigns have risen 150% from $24 0 $60 million. With those returns on wealth and income, an overwhelming majority of U.S. taxpayers would volunteer themselves to be regulated.
Imagine how much better capitalized U.S. banks could be, or how much they could lend to individuals and businesses, if in the last two decades, their misdeeds had not cost them over a quarter of a trillion dollars in fines due, to violations in the areas of securities trading, consumer protection, anti-trust laws, fraud, money laundering, economic sanction, and terrorism financing.
U.S. banks were resilient between 2020 through February 2023, even while being impacted during the unprecedented economic stress brought on by COVID-19. Basel III and the Dodd-Frank Act capital, liquidity, stress test, and living will requirements were critical in helping banks survive unexpected losses. Even as robust as those frameworks are, however, they probably would not have been enough. Fiscal and monetary policy stimuli bolstered banks’ balance sheets and were critical to the stability of the United States.
Risks always differ, because the size and complexity of markets and banks continually change. In addition to operational and financial risks, banks now also face cybersecurity, climate change, rising civil unrest domestically, and geopolitical threats. Unfortunately, those risks are barely covered by existing or proposed rules.
Banks are not at historically high levels of capital. By updating changes to Basel III and Dodd-Frank, U.S. bank regulators are fulfilling their mission of ensuring the safety and soundness of the American banking system. Regulators’ proposed rules will not be final until next year, and the implementation would begin one to two years thereafter. Banks have plenty of time to conduct gap analysis to determine what personnel or technological resources they need to comply. Banks have known for over five years that updated Basel III rules were coming, especially since the U.S. is a long-standing influential member of the Basel Committee on Banking Supervision. U.S. regulators gave the industry over 120 days to comment on the proposed rules.
Under no circumstances should regulators withdraw any of the proposed rules. The rule is working as it should. The protection of American citizens is at the heart of why I am advocating for rules that will protect the American banking system. I hope that legislators and regulators share this value as well.
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