In response to the suggestion – put forward by bankers and central bankers in the UK – that a temporary cut in capital adequacy requirements would stimulate new lending and economic growth, The Banker has simulated how a 1% lower Basel requirement might affect various major world economies.

Feb 2012 - 1% CA

The UK’s Project Merlin, a government deal to boost bank lending to small and medium-sized enterprises (SMEs), appears to be fading into obscurity without hitting its targets. One senior banker recently mused to The Banker that simply cutting capital requirements by 1% might have been a better alternative, because it would increase the asset origination power of UK banks.

This echoes comments made by Andrew Haldane, executive director of financial stability at the Bank of England, in August 2011. He suggested a temporary cut to bank capital adequacy requirements to stimulate credit to the economy, and hopefully revive growth. The required ratios could then be hiked again once economic activity has recovered.

Using end-2010 aggregated data for bank balance sheets, The Banker decided to take a look at what a 1% cut in capital requirements might mean for major world economies. This requires us to make a host of assumptions. First, we assume that all banks will want to keep the existing safety margin between the regulatory minimum capital requirement and their current capital adequacy ratio. In other words, all banks would simply lower their Basel capital adequacy ratio by exactly one percentage point, regardless of how near or far they currently are from the minimum level required.

Since the Basel capital adequacy ratio is calculated based on Tier 1 capital divided by risk-weighted assets, we have had to assume that the average risk-weighting assigned to assets in each country remains the same. And we also assume that the proportion of gross total loans to total assets remains the same.

UK the winner

The end result is eye-catching. It is certainly clear why UK bankers and central bankers might have suggested this idea. A 1% cut in capital requirements allows the country the largest increase in assets in our sample, at almost 37% of gross domestic product (GDP). The Netherlands follows close behind, but the US might be less enthusiastic – the cut would only increase potential assets by just short of 8% of GDP. Interestingly, because gross total loans in the UK are a lower proportion of total assets, both Spain and the Netherlands would enjoy a greater boost in actual lending.

Feb 2012 1% 2

Of course, this is not the whole story. The reason why a lower capital ratio would have such a great impact in the UK is because of the size of bank assets relative to the economy (see chart two). But many of those assets are not domestic. Banks such as HSBC or Standard Chartered have the majority of their assets in foreign markets, so lower capital adequacy requirements might provide more of a stimulus in Asia or the Middle East than in the UK.

The other crucial variable is the risk-weighting of assets. Banks in certain countries, most notably Germany and the Netherlands, have been particularly aggressive in assigning low average risk-weights to their assets. This allows for a larger increase in total assets if the capital requirement is cut. The difference with the US is stark, prompting American banks to complain that Basel is not a level playing field. But as we have noted before, US banks benefit from more generous accounting rules on derivatives, which also serve to lower their gross total asset calculations.

In two cases, however, the benefit of this capital ratio cut is directly related to the fact that their banks were more highly leveraged at the end of 2010. Italy and Spain were the only countries in this sample with aggregate Tier 1 to risk-weighted assets ratios of less than 10%. With both banking sectors battling to raise capital over the past year, the economic benefits of a 1% capital ratio cut would now be less marked.

PLEASE ENTER YOUR DETAILS TO WATCH THIS VIDEO

All fields are mandatory

The Banker is a service from the Financial Times. The Financial Times Ltd takes your privacy seriously.

Choose how you want us to contact you.

Invites and Offers from The Banker

Receive exclusive personalised event invitations, carefully curated offers and promotions from The Banker



For more information about how we use your data, please refer to our privacy and cookie policies.

Terms and conditions

Join our community

The Banker on Twitter