It is now three years since financial authorities began working feverishly to ward off a systemic collapse. They have been providing emergency assistance at the same time as they seek to prevent a relapse. And, like good doctors adhering to their Hippocratic oath, officials are on guard so that they do no harm. With this in mind, they are examining to what extent the benefits of more stringent regulation and supervision outweigh the potential costs.
A clear answer comes from two papers released this week by the Financial Stability Board (FSB) and the Basel Committee on Banking Supervision (BCBS). The first study looks at the long-term impact of stronger capital and liquidity requirements,* the second at the transitional economic impact as the requirements are phased in.** Taken together, they show that the benefits of such measures will be significant, while the costs are likely to be very modest.
The motive for regulation is that, if banks are left to their own devices, they hold too little capital and too little liquidity. Lower capital means higher returnson equity but a smaller buffer against loan defaults and investment losses. Less liquidity, implying a higher fraction of long-term assets funded with short-term debt, raises profits but heightens exposure to sudden withdrawals and difficulties in rolling over debt.