By Manos Schizas, senior SME policy adviser, ACCA
As of today, we are one step closer to the answer. The Bank for International Settlements (BIS) has finally published their interim impact assessment (in two parts) of increased capital and liquidity requirements. It is a massive undertaking of qualitative and quantitative research and reading only a couple of pages can make one's head hurt, but I strongly suggest you give it a go. It really is that important.
The first of the two reports, which deals with the immediate macroeconomic effects of higher capital and liquidity requirements, can be read here.
BIS' median scenario estimates that for every 1 percentage point rise in the target capital ratio (tangible common equity / risk adjusted assets) the following are likely to take place:
'Changes in lending spreads alone are estimated to reduce GDP relative to the baseline trend by roughly 0.16% in the four-year implementation case.
'Taking account of [credit supply] effects, by incorporating indicators of bank lending standards into models, yields a median reduction in GDP of 0.32% after four and a half years (again, per percentage point increase in the capital ratio). Models that incorporate the impact of both higher lending spreads and supply constraints tend to yield some of the largest impact estimates, perhaps because they were calibrated based on past data that include episodes when deep recessions coincided with persistent banking sector strains. This underlines the importance of implementing new regulatory requirements in a way that is compatible with the ongoing economic recovery.
'These GDP effects reflect median increases in domestic lending spreads of about 15 basis points, and declines in lending volumes of 1.4%.
'An easing of monetary policy [interest rates, QE?] reduces the estimated output losses. When it is assumed that the central bank responds to the incipient aggregate demand fall and reduced inflationary pressures precipitated by the regulatory changes, the central estimate of the maximum output loss shrinks significantly. Such offsets are especially pronounced in models that incorporate credit supply constraints, for which the GDP loss in the 18th quarter falls from 0.32% to 0.17%.' (pp. 3-4)
To this must be added an additional reduction in GDP of:
'0.03%, which is the potential impact of international spillovers (reflecting exchange rates, commodity prices and shifts in global demand) as estimated by the IMF' (pg. 3)
If the BIS estimates are accurate, then it appears that bankers have slightly overplayed their hand. BIS note that this is about one eighth of the impact calculated by the Institute of International Finance, which can be found here:
BIS have also tested the effect of higher liquidity requirements:
'The MAG also examined the impact of tighter liquidity requirements, which were modelled as a 25% increase in the holding of liquid assets, combined with an extension of the maturity of banks’ wholesale liabilities. The estimations, which were run separately from those for higher capital standards, yield a median increase in lending spreads of 14 basis points and a fall in lending volumes of 3.2% after four and a half years. This is estimated to be associated with a median decline in GDP in the order of 0.08% relative to the baseline trend. It is important to emphasise that the estimates of the impact of enhanced liquidity requirements do not take account of their interaction with the capital rules. Because meeting one helps banks meet the other, the combined effect of both measures is almost certainly less than the sum of the individual impacts.' (pg. 4)
Small business bodies and ACCA have called for a detailed SME impact assessment before any decisions are made on capital requirements and as such will be keen to examine the BIS paper. The BIS impact assessment is of course a macro study and as such was never going to look too deeply into differential effects by firm size, but some basic points emerge from its analysis.
- The report notes that the effect of higher capital requirements on small and medium-sized enterprises is a risk to the estimate and will likely be disproportionately large due to the lack of alternatives to bank lending (pp. 11 & 31).
- It also explains that it is very difficult to model the precise effect due to difficulties in anticipating the responses of lenders (pp 29-30, 34). One disturbing scenario that is highlighted in the report is Japan's experience in the late 90s, during which higher capital requirements appear to have been followed by a quadrupling of defaults as compared to the early 90s due to a deep SME credit crunch. (pg. 51)
- SMEs are singled out as one sector which, if disproportionately affected by capital requirements, could make a substantial difference to their effect on economic growth in general (pg. 34).
- Finally the report suggests that a longer implementation period might benefit SMEs (pg. 5).
In one sense, this tells SME stakeholders very little that we didn't know already. What little information the report does provide suggests that what policymakers need in order to optimise capital requirements is a credible signal from lenders of how they will respond to increased capital requirements with regard to SME lending. Credibility is very important to this exercise, because it is in lenders' interest to signal that they will be forced to cut SME lending savagely under higher capital requirements – thus forcing policymakers to opt for more lenient requirements.
This may well be the case if small businesses (not even SMEs!) account for about 46% of the risk adjusted assets of major retail banks, as suggested by this year's World Retail Banking Report.
If any reader who is a keen game theorist would like to model this signalling process, they can email me at firstname.lastname@example.org
While we wait for the game theorists to arrive, we can go out on a limb and use a recent report by EIM and CSES for the European Commission to look at how the median BIS-estimated fall in GDP might correspond to changes in SME lending. The report can be found here.
Scaling the effect down from the EIM-CSES estimates would suggest that each percentage point added to capital adequacy ratios would come at the price of a 0.34% decrease in bank lending to small businesses, a 0.5% decrease in bank lending to medium-sized businesses, a 1.2% decrease in factoring, a 0.77% decrease in leasing and a 2.2% decrease in venture capital funding. Bank lending to small businesses would fall by just under 1% under some of the worst scenarios.
I suspect that is a price some small business advocates will be willing to pay if it means avoiding a repeat of 2008-9, but will it?
To be continued.
Update: The FT’s Alphaville has had a look at this too.