Economic Notes by Banca Monte dei Paschi di Siena SpA,

vol. 40, no. 3-2011, pp. 7591

Do Bank Capital and Liquidity Affect Real

Economic Activity in the Long Run? A VECM
Analysis for the US
LEONARDO GAMBACORTA

This paper analyses the long-term economic costs of the new regulatory
standards (the so-called Basel III reform) for the US. Using a Vector
Error Correction Model that estimates long-run relationships among
a small set of macro-variables over the period 19942008, it shows
that tighter capital and liquidity requirements have negative (but rather
limited) effects on the level of long-run steady-state output and more
sizeable effects on banks return on equity. The economic costs are
considerably below the estimated positive benefit that the reform should
have by reducing the probability of banking crises and the associated
banking losses (BCBS, 2010b).
(J.E.L.: E44, E61, G21).

1. Introduction

The cornerstone of the Basel III package for more resilient banks
is a strengthened common equity buffer together with newly introduced
liquidity requirements and a leverage cap to be phased in over an extended
timetable running to the end of 2018 (BCBS, 2010d). The analysis of the
economic effects of the Basel Committees proposed capital and liquidity
regulation on output is summarized in BCBS (2010b), the so called Longterm Economic Impact (LEI) report.1 This paper details one of the many
pieces of work that informed this report and tries to answer the following
question: what is the impact of higher capital requirements and tighter
liquidity regulation on the long-term economic performance of the US?

Monetary and Economic Department, Bank for International Settlements, Centralbahnplatz

2, Postfach, 4002 Basel, Switzerland. E-mail: leonardo.gambacorta@bis.org
I would like to thank Paolo Angelini, Claudio Borio, Carlotta Rossi, Kostas Tsatsaronis and,
in particular, two anonymous referees for useful comments and discussions. The opinions expressed
in this paper are those of the author and do not necessarily reflect those of the Bank for International
Settlements (BIS).
1
A parallel study analyses the macroeconomic impact of the transition to stronger capital
and liquidity requirements [the so-called Macroeconomic Assessment Group (MAG) report, MAG
(2010a,b)].


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In particular, this paper presents results obtained with a Vector Error

Correction Model (VECM) that estimates long-run relationships among
a small set of macro-variables over the period 19942008. The main
advantage of this approach is that it helps to disentangle loan demand
and loan supply factors in the steady state. The main disadvantages are
that it does not allow counterfactual experiments to be conducted, and that
the estimates are potentially subject to the Lucas critique.
The main result of the paper is that tighter capital and liquidity
requirements have rather limited negative effects on the level of longrun steady-state output and more sizeable effects on bank ROE. The
calculated economic costs are therefore considerably below the estimated
positive benefit that the reform should have by reducing the probability
of banking crises and the associated banking losses (BCBS, 2010b). This
analysis focuses on the long-run effects on interest rates, lending, GDP
and bank profitability due to changes in banking regulation. It is therefore
complementary to the studies that look at transitional impacts, such as
those summarized in MAG (2010a), which use a variety of modelling
approaches, or Berrospide and Edge (2010), which analyses the short-term
effects of bank capital on lending using a VAR approach.
The paper is organized as follows. Section 2 reports a descriptive
analysis of the data and identifies possible breaks in the estimation period.
Section 3 shows the characteristics of the VECM model and discusses the
long-run relationship between the variables using Johansens methodology.
Section 4 presents the impact of tighter regulation on the steady state
of the model. After the analysis of forecast error variance decomposition
(FEVD) decomposition and the short-term dynamics in Section 5, Section 6
compares the results of the paper with those of other studies and calculates
the net benefits of the new regulation. The last section summarizes the
main conclusions.

2. Data Description

The VECM is based on quarterly data for the US over the period
1994:q12008:q3.2 The interaction between the credit market and economic
activity is analysed by means of the following variables: (i) the logarithm
of real GDP (Y); (ii) the short-term real interest rate (i ); (iii) the spread
between the average lending rate and the short-term interest rate (r i);
2
The sample period starts from 1994 because of the limited availability of the series for the
liquidity-to-deposit ratio. At that date all major institutional changes that affected competition in
the US credit market, including the effects of the introduction of the Basel I accord, had already
taken place (Dynan et al., 2006). In order to exclude the effects of unconventional monetary policy
actions (Borio and Disyatat, 2009; Chung et al., 2011), the database ends in the third quarter of
2008, with the Lehman default.


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Figure 1: Bank Lending, Government Expenditure and GDP

Note: All variables are expressed in logs.

(iv) the logarithm of lending to the private sector in real terms (L); (v) the
logarithm of the Return on equity of US banks in real terms (ROE)3 ; (vi)
the logarithm of the liquidity-to-deposit ratio (LIQ); (vii) the logarithm of
TIER1/RWA (CAP); (viii) the net tightening indicator on commercial and
industrial (C&I) loans to large an medium-sized firms obtained from the
Bank Lending Survey (BLS); (ix) the logarithm of government consumption
and expenditure in real terms (G). All series are seasonally adjusted when
seasonality is detected.
The real GDP and bank lending series are those compiled by the
IMF. A graphical analysis of the behaviour of annual percentage changes
in GDP and credit is reported in Figure 1. It shows a high correlation
between the series (except during the last quarter of 2008 affected by
the financial crisis), suggesting the possibility that they are cointegrated.
For example, better economic conditions usually increase the number of
projects that become profitable in terms of expected net present value and
hence increase the demand for credit (Kashyap et al., 1993). This suggests
the presence of a long-run relationship between credit and GDP. A similar
pattern can be detected between government expenditure and real economic
activity.
The composite lending rate (r) is obtained by weighing bank lending
rates on different types of loans (mortgage rates, commercial and industrial
3
I have taken logs of the difference between the nominal ROE and the consumer price
inflation.


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Figure 2: Short-Term Real Interest Rate and Lending Spread

Note: The short-term real interest rate is given by the three-month interbank rate minus CPI
inflation. The spread is the difference between the lending rate and the three-month
interbank rate.

lending rate). The weights are given by the relative importance of the
corresponding loan category. The real short-term interest rate is given by
the three-month interbank rate minus CPI inflation (i ). The behaviour
of the spread (r i) and that of the real short-term interest rate are
reported in Figure 2. The increase in the spread that occurred in the period
20012005 is not due completely to the increase in the delinquency rate
and goes hand in hand with an easing in bank lending standard (BLS)
conditions. This period is likely influenced by the consequences of the
bursting of the dot-com bubble.4
Due to financial innovation and the widespread use of securitization
techniques the liquidity ratio falls over time (see Figure 3). The change in
banks business models from originate and hold to originate, repackage
and sell had significant implications for financial stability and the transmission mechanism of monetary policy (Altunbas et al., 2009). The ability
of banks to sell loans promptly and obtain fresh liquidity, coupled with new
developments in liquidity management, has also lowered banks needs to
4
In a previous version of the paper, I have also tried to include the delinquency ratio as an
additional variable to explain the behaviour of banks interest rate setting. However, results were not
satisfactory because of a structural break in the relationship between the delinquency rate and the
spread in the period 20012005. This structural break could have been driven, at least partly, by the
extremely low level of short-term interest rates (Taylor, 2009) and an increase in banks risk-taking
(Altunbas et al., 2010).


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Figure 3: Liquidity Ratio, Capital Ratio and Bank Return on Equity

Note: All variables are expressed in logs.

hold certain amounts of risk-free securities on the asset side of their balance
sheet. This has, in turn, distorted the significance of standard liquidity ratios
(Gambacorta and Marques, 2011). As expected, bank profitability exhibits
a significant drop during the period of financial turmoil.

3. The VECM

We start with a nine-variable VAR system; all the variables, that are
found to be I(1), are treated as endogenous, except government expenditure
(G).5 Therefore, the starting point of the multivariate analysis is
(1)

zt = +

p


k ztk +

k=1

p


k Gtk + t

t = 1, . . . , T

k=1

t VWN(0,)

5
The public expenditure has been considered an exogenous variable. This hypothesis has
been tested in a VAR model where all interest rates are treated as endogenous variables. The
null hypothesis of weak exogeneity of the government expenditure is accepted with a P-value of
14.5 per cent. Following Harris (1995), we have therefore removed the equation for government
expenditure from the system.


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Table 1: Trace Tests for the Cointegration Rank

Rank
0
1
2
3
4
5
6
7

Statistic

P-value

50%

80%

90%

95%

97.50%

99%

282.2
199.2
129.3
82.9
53.2
31.5
18.9
6.5

0.000
0.000
0.000
0.016
0.061
0.069
0.077
0.161

143.3
111.4
83.6
59.6
39.7
23.6
11.5
3.5

156.2
122.8
93.5
68.1
46.7
29.2
15.5
6.0

163.2
129.1
99.1
72.9
50.6
32.4
18.0
7.6

169.2
134.5
103.8
77.0
54.1
35.2
20.1
9.2

174.5
139.2
108.0
80.6
57.2
37.8
22.1
10.7

180.8
144.9
113.0
85.0
61.0
40.9
24.6
12.6

Notes: Johansen -trace tests take into account the adjustment for d.f. proposed by Reimers (1993) for
small samples. Asymptotic critical values are provided in Osterwald-Lenum (1992), although due to the
presence of a dummy variable and an exogenous variable they are only indicative.

where zt = [y, i , r i, L, ROE, LIQ, CAP, BLS] and t is a vector

of residuals. The deterministic part of the model includes a constant6 ; the
number of lags (p) has been set equal to three based on the Likelihood
ratio suggested by Sims (1980). The analysis of the system showed serially
uncorrelated residuals. Normality of the VAR may be achieved with the
introduction of an impulse dummy for 2001:q3, for the effects of terrorist
attack on September 11.
The I(1) nature of the variables included in zt implies that one or more
cointegrating relationships may exist. Equation (1) is then rearranged as a
reduced-form error correction model:
(2)

zt = (, zt1 , Gt1 ) +

p1


k ztk

k=1
p1

Hk Gtk + t

t = 1, . . . , T

k=1

= (1 I ) = 
where the constant is included in the cointegration space.
This framework can be used to apply Johansens trace test to verify
the order of integration of the matrix . In fact, the rank of determines
the number of cointegrating vectors (r) such that is an n r matrix of
loading coefficients and is an n r matrix of cointegrating vectors. The
results show the presence of four cointegrating vectors in the model (see
Table 1).
We detect four possible long-term relationships among the variables.
The first cointegrating vector represents banks spread setting. Freixas and
6
The choice of the deterministic component (constant vs. trend) has been verified by testing
the joint hypothesis of both the rank order and the deterministic component (so-called Pantula
principle).


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Rochet (1997) show that in a model of imperfect competition among N

banks each one sets the lending rate as the sum of the exogenous cost
of banks refinancing on the money market, other costs (such as bank
capital and liquidity requirements) and a constant markup. Economic theory
therefore shows that the difference between the lending rate and the money
market rate can be represented as: r i = 0 + 1 LIQ + 2 CAP. This
equation can be also interpretable as a perfectly horizontal loan supply for
given levels of capital and liquidity.7
The second long-run relationships is a CC curve (Bernanke and
Blinder, 1988), where the IS curve is modified to take into account for
the existence of the credit market (from this the acronym CC that stands
for Commodities and Credit). The existence of the bank lending channel
is considered by means of the spread: an increase in the latter captures
a tightening in lending supply that, given the hypothesis of imperfect
substitutability between loans and other forms of firms financing, should
produce a drop in investment and output. The CC curve has the following
form: Y = 0 + 1 (i )) + 2 (r i) + 3 G.
The third long-term relationship is a lending demand equation. Bank
lending demand should be a positive function of real GDP and a negative
function of the spread. In other words, we suppose the existence of a
log-linear long-run relationship of the following type: L = 0 + 1 Y +
2 (r i).
The fourth long-term relationship is given by a reduced form for bank
profit. In the long-run bank return on equity depends on financial deepening
(the ratio between total lending and GDP) and the spread. We have:
ROE = 0 + 1 L/Y + 2 (r i).
The estimated long-run relationships are the following (with standard
error in brackets):
(3)

r i = 0.061 LIQ + 0.148 CAP + 0.607

(4)

Y = 1.344 (i ) 3.934 (r i) + 0.811 G + 3.373

(0.002)

(0.295)

(0.145)

(5)

(6)

(0.008)

(0.019)

(0.0246)

(0.193)

L = 1.350 Y 2.016 (r i) 3.2854

(0.016)

ROE = 6.510
(0.411)

(0.162)

(0.1492)

L
+ 3.684(r i) + 0.607
(0.462)
(0.238)
Y

7
BLS conditions did not enter significantly the supply equation. The Senior Loan Officer
Survey for US banks reports the net percentage of banks that tight (positive value) or ease (negative
value) lending conditions with respect to the previous quarter. By nature, this variable should enter
the spread and the lending equation in the short term and have no effect in the long term. This result
is also consistent with the evidence provided in Berrospide and Edge (2010).


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The set of over-identified restrictions is accepted with a P-value of

7 per cent.
As for the estimated coefficients, the long-run elasticity between the
spread and the two regulatory variables are quite low. In case of a
1 percentage point increase of the liquidity ratio or the capital to asset
ratio, the spread increases, respectively, by 0.06 and 0.15 per cent.
The second long-run equation shows, as expected, a negative relationship between GDP and both the real interest rate and the spread. The
elasticity between GDP and real public expenditure is 0.8.
The long-run elasticity between lending and GDP is equal to 1.3, which
is in line with results for the euro area (Calza et al., 2006; Gambacorta
and Rossi, 2010). An income elasticity above one is likely to reflect
the omission of some variables from the model such as wealth or house
purchases that are not captured by GDP transactions. The semi-elasticity
of bank loans with respect to the spread is negative ( 2.0).
As for the fourth cointegrating vector, the long-run elasticity between
ROE and L/Y is quite high (6.5) and it is likely to reflect the omission
of some variables from the model such as the stock market behaviour
that could capture the dynamic of the non-interest income component that
are not captured by a traditional indicator of credit deepening. The semielasticity of bank loans with respect to the spread is positive (3.8).

4. Impact on the Steady State of Tighter Capital and Liquidity Requirements

Two sets of policy scenarios are considered, for capital and for
liquidity, respectively. Following MAG (2010a) and BCBS (2009, 2010b),
the scenarios were designed considering tangible common equity (TCE), a
concept closely related to the TIER 1 capital measure chosen in the Basel
III accord. Specifically, it was assumed that the capital tightening could be
proxied by a 2, 4 or 6 percentage points increase in the ratio between TCE
and Risk-Weighted Assets (RWA).8 In particular, the idea was to gauge
the reactivity of the economy to capital increases of different magnitudes,
and checking for the presence of nonlinearities. Since the VECM analysis
has been conducted using the TIER1/RWA ratio we convert this measure
into a TCE/RWA ratio using the conversion metric provided in annex 5 of
BCBS (2010b).
The modelling of the liquidity reform presents greater challenges.
Under the BCBSs December 2009 proposal, banks would be required to
8
We define capital as TCE and the capital ratio as the ratio of TCE to RWA. TCE is net
of goodwill and intangibles. RWA are measured using historical definitions under Basels I and II.
The analysis applies to total TCE held, so that it does not distinguish between the minimum capital
requirement and additional capital that banks may hold in excess of the minimum requirement; see
BCBS (2010c).


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Table 2: Impact of Regulatory Tightening in the Steady State

Target
liquidity
tightening,
relative to
steady-state
level(a)
(percentage
increase)
0
0
0
25
25
25
50
50
50

Increase in
capital ratio
(Tangible Common
Equity/RWA)
relative to
steady-state
level(b)
(percentage
points)
2
4
6
2
4
6
2
4
6

SPREAD
(ri)

GDP
(Y)

LENDING
(L)

RETURN ON
EQUITY
(ROE)

(percentage and per cent points deviation from

baseline)
0.05
0.10
0.15
0.06
0.11
0.16
0.08
0.13
0.18

0.19
0.39
0.58
0.25
0.45
0.64
0.31
0.51
0.70

0.36
0.72
1.09
0.47
0.84
1.20
0.59
0.95
1.31

0.92
1.83
2.75
1.20
2.12
3.03
1.48
2.40
3.32

Notes: (a) The liquidity ratio is defined as the sum of cash, government securities and net interbank
lending over total deposits. Meeting the NSFR without considering the impact on RWA is assumed to
translate into a 50% increase in the liquidity ratio, whereas taking the synergies of liquidity and capital
regulation into account reduces the impact to 25%.
(b)
The increase of the TCE/RWA ratio has been mapped into changes of the TIER1/RWA ratio by using
the metric proposed in annex 5 of BCBS (2010b).

meet two new liquidity requirementsa short-term requirement called the

Liquidity Coverage Ratio (LCR) and a long-term requirement called the Net
Stable Funding Ratio (NSFR). The LCR ensures that banks have adequate
funding liquidity to survive one month of stressed funding conditions. The
NSFR addresses the mismatches between the maturity of a banks assets
and that of its liabilities. In this paper, following BCBS (2010b), I focus
only on the NSFR, seen as the more relevant constraint for macroeconomic
effects in the long run. In addition, data limitations made it especially hard
to analyse the LCR for national banking systems.
The approach adopted is to consider a 25 or 50 per cent increase in
the ratio between banks liquid and total assets. The analysis developed by
King (2010) and incorporated in BCBS (2010b) suggests that meeting
the NSFR can be modelled by a 50 percent increase in the liquidity
ratio; however if banks increase liquid assets to reach a higher liquidity
ratio, other things equal, risk-weighted assets decline and the TCE/RWA
ratio increases, helping banks meet the tighter capital requirements. The
estimates reported in BCBS (2010b) suggest that if these synergies between
capital and liquidity regulation are taken into account, meeting the NSFR
can be modelled by 25 per cent increase in the liquidity ratio.
Table 2 summarizes the results. The impact of changes in capital
and liquidity ratio on the spread is quite small. For example, in case of

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a 6 percentage points increase of capital requirement, banks increase the

spread by 15 basis points; this impact is only slightly higher if also liquidity
requirements are increased reaching a total of 18 basis points. This impact
is in line with recent studies measuring the long-run effects of higher capital
requirements on banks lending spreads. Elliot (2009, 2010) and Hanson
et al. (2010) for the US and Bank of England (2010) and Osborne et al.
(2010) for the UK argue that these effects are modest, especially if banks
are able to offset the increase in funding costs, e.g., through a reduction
in banks required return on equity and a decrease in borrowing costs, as
banks become safer.9
It is worth observing three facts. First, the model captures the effect of
bank competition and allows credit intermediaries to adjust their return on
equity in response to bank capital and liquidity change. The last column
of the table shows that the simulated regulatory changes induce a drop of
the ROE in the banking industry up to 3.3 percentage points in the tighter
scenario. Imposing no long-run impact on the ROE would have probably
increased the impact on the spread to contain the drop in supplied lending.
This is what happens in King (2010).
Second, in 2008 the liquidity ratio was lower than 4 per cent in the
US and above 15 per cent in the euro area (Castiglionesi et al., 2010).
This means that the proposed increase of 25 or 50 per cent is relatively
less important in the US than in the euro area. Using a different measure
for liquidity (cash and government bonds over total assets) reduces the gap
between US and the euro area and produces a higher impact on the spread.
This means that simulations on liquidity are sensitive to the measure used
in the analysis.
The low impact on the spread translates into a limited effect on output.
Each 1 percentage point increase in the capital ratio translates into a
0.1 per cent drop in the level of steady-state output relative to the baseline.
Even in this case, output is mainly affected by changes in bank capital
requirements. The impact of meeting the NSFR is of a similar order of
magnitude.

5. FEVD Decomposition and Transition Path towards the Equilibrium

In order to evaluate how much of the variability of the lending spread

is driven by changes in the liquidity and capital ratios, I have computed the
FEVD for the variable SPREAD. This exercise helps us to get a sense of
the amount of information coming from each variable in the formation
of banks markup. Figure 4 shows that a substantial part of the variability
9
The ModiglianiMiller theorem is a sufficient but not a necessary condition for this result
to hold. See Hanson et al. (2010) and Admati et al. (2010) for a discussion.


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Figure 4: Forecast Error Variance Decomposition (FEVD) for the Lending Spread

of the lending spread is explained by the capital ratio and by the level
of the real interest rate. The liquidity ratio has a very limited role. This
could be dueas explained in Section 2by the impact of securitization
technique that has limited the information content of the liquidity ratio.
Similar conclusions can be derived by analysing the FEVD of bank
lending and of GDP.10 In both cases, a non-negligible amount of the
variability is driven by the capital ratio and financial variables, mainly
the real interest rate. This exercise indicates that output fluctuations in
the long run are not simply driven by real factors such as productivity
(technological) shocks or adjustments in capital and labour markets.
The analysis of this paper focuses on the long-term relationships
between the variables. However, some insights can be derived also by
analysing the transition path towards the equilibrium in case of an exogenous shock. In particular, some additional information can be obtained also
by investigating the matrix of the loading coefficients of the error correction
10

The figures are not reported for the sake of brevity but are available from the author upon

request.

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terms. The latter indicate how much of the dynamic path towards the longrun equilibrium is explained by the error correction factors. For example,
the loading coefficient of the CC curve (Equation 4) in the equation for
GDP is equal to 0.15. This means that in the case of an exogenous shock
bringing the system away from equilibrium, 15 per cent of the adjustment
towards the new equilibrium will take place within one quarter (95 per cent
of the adjustment is completed after 18 quarters). Similar considerations
can be made for the bank lending equation in which the loading coefficient
of the lending demand relationship (Equation 5) is equal to 0.18. The
loading coefficient of the markup long-run relationship in the banks spread
equation is equal to 0.56: more than half of the adjustment takes place in
one quarter and it is completed after one year. On the contrary, the loading
coefficient of the long-run relationship for bank profitability (Equation 6) in
the ROE equation is very low ( 0.06), indicating a very slow adjustment
process in case of an exogenous shock to banks profits.

6. A Comparison with Other Studies and Calculation of the Net Benefits

The results of this study are in line with other two studies that perform
a similar analysis. The first one is Angelini et al. (2011) who analyse
the effects of new capital and liquidity requirement on 13 models (mainly
DSGE and semi-structural models), including the model presented in this
paper. In this case, each 1 percentage point increase in the capital ratio
translates into a 0.09 per cent loss in the level of steady-state output,
relative to the baseline (median across the point estimates of the available
models). Similar results are obtained using the welfare-based measures. The
median impact of meeting the NSFR is of a similar order of magnitude, at
0.08 percent.
The results of this study are also in line with MAG (2010b) which
calculates simulated paths for GDP extending to 2022 using a variety of
models and assumptions. Although most of these models are primarily
designed to estimate short- and medium-term policy effects, the end-ofperiod (2022) loss relative to the baseline can be taken as an alternative
measure of the long-term impact of the new regulation. This loss is
0.10 per cent using a median value across all models.
Overall, the economic costs associated with tighter capital and liquidity
standards are considerably lower than the estimated positive benefit that
the reform should have by reducing the probability of banking crises and
their associated banking losses.
Figure 5 compares the economic costs find in this study (dotted line)
with expected benefit (continuous line) of stronger capital and liquidity
regulation in terms of their impact on output (BCBS, 2010b). The main
benefits of a stronger financial system reflect a lower probability of

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No permanent effects

Benefits and costs

Benefits and costs

Moderate permanent effects

87

TCE/RWA

TCE/RWA

Figure 5: Long-run Expected Annual Benefits and Costs of Tighter Regulation

Notes: Benefits and costs (vertical axis) are measured by the percentage impact on the level of
output. The capital ratio is defined as TCE over RWA. The origin corresponds to the pre-reform
steady state, approximated by historical averages for total capital ratios (7 per cent) and the
average probability of banking crises. Net benefits are measured by the difference between
expected benefits and expected costs. Expected benefits equal the reduction in the probability of
crises times the corresponding output losses. The two panels refer to different estimates of net
benefits, assuming that the effects of crises on output are permanent but moderate (left-hand
panel) or only transitory (right-hand panel). For more details, see BCBS (2010b, pp. 2831).

banking crises and their associated output losses. Another benefit reflects a
reduction in the amplitude of fluctuations in output during no-crisis period
but these benefits are not taken into account by the values presented in
Figure 5. These changes should be interpreted relative to the pre-reform
steady state, proxied by the historical average level of the TCE/RWA ratio
(7 per cent) and frequency of banking crises with the liquidity requirements
(NSFR) being met. The Figure is divided in two panels. In the first panel,
the benefits (cost of banking crises, taken straight from the LEI study) are
estimated with moderate permanent effects; in the second panel, we report
the very conservative scenario where the costs of the banking crises are
estimated as only temporary. The core message of the Figure is that even
under restrictive assumption net benefits remain positive for a broad range
of capital ratios.
7. Conclusions

This paper analyses the long-term economic costs of the new regulatory
standards (the so-called Basel III reform) for the US. Using a VECM
that estimates long-run relationships among a small set of macro-variables
over the period 19942008, it shows that tighter capital and liquidity
requirements have negative (but rather limited) effects on the level of longrun steady-state output and more sizeable effects on bank profitability.
Each 1 percentage point increase in the capital ratio translates into a
0.1 per cent drop in the level of steady-state output relative to the baseline.

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The impact of meeting the NSFR is of a similar order of magnitude. These

results are in line with other studies (MAG, 2010b; Angelini et al., 2011).
Overall, the economic costs associated with tighter capital and liquidity
standards seem to be considerably lower than the estimated positive benefit
that the reform should have by reducing the probability of banking crises
and the associated banking losses (BCBS, 2010a, b). However, the precise
mapping between the higher capital level and stricter liquidity standards, on
the one hand, and the reduction in the probability of a crisis, on the other, is
quite uncertain. No single approach can capture all the implications of the
Basel III package for bank behaviour and the economy at large, and more
research is needed to provide a full understanding of the main linkages at
work. The results of this paper should also be viewed with caution because
the period analysed here does not include a major recession and therefore
simulations could not properly estimate the long-run macro impact.


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89

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Non-technical Summary

This paper analyses the long-term economic costs of the new regulatory
standards (the so-called Basel III reform). In particular it details one of the
many pieces of work that informed the so-called Long-Term Economic
Impact (LEI) report and tries to answer the following question: what is the
impact of higher capital requirements and tighter liquidity regulation on
the long term economic performance in the United States?
In order to answer this question we use a Vector Error Correction
Model that estimates long-run relationships among a small set of macrovariables over the period 19942008. The main advantage of this approach
is that it helps to disentangle loan demand and loan supply factors in the
steady state. The main disadvantages are that this model does not allow
counterfactual experiments to be conducted, and that the estimates are
potentially subject to the Lucas critique.
The results of the paper show that tighter capital and liquidity requirements have rather limited negative effects on the level of long-run
steady state output and more sizeable effects on bank ROE. The calculated
economic costs are therefore considerably below the estimated positive
benefit that the reform should have by reducing the probability of banking
crises and the associated banking losses. In particular, each 1 percentage
point increase in the capital ratio translates into a 0.1% drop in the level
of steady state output relative to the baseline. The impact of meeting the
Net Stable Funding Ratio is of a similar order of magnitude. These results
are in line with other studies. Overall, the economic costs associated with
tighter capital and liquidity standards seem to be considerably lower than
the estimated positive benefit that the reform should have by reducing the
probability of banking crises and the associated banking losses. However,
the precise mapping between the higher capital level and stricter liquidity
standards, on the one hand, and the reduction in the probability of a crisis,
on the other, is quite uncertain. No single approach can capture all the
implications of the Basel III package for bank behaviour and the economy
at large, and more research is needed to provide a full understanding of
the main linkages at work.


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2012 The Author

C 2012 Banca Monte dei Paschi di Siena SpA.
Economic Notes