Basel III: Is the Cure Worse than the Disease?

TLDR: In this paper, the authors find that the costs of credit to low risk bank borrowers will be only moderately affected by the changes in bank balance sheets, but that there will be a reduction in availability and higher cost at the riskier end of the credit spectrum.

Abstract: Basel III will force banks to shift their business model from liability management, in which business decisions are made about asset volumes, with the financing found in short term wholesale markets as necessary, to asset management, in which asset volumes are constrained by the availability of funding. We find, contrary to what many have argued, that once there is a full adjustment, the costs of credit to low risk bank borrowers – the majority of customers – will be only moderately affected; but that there will a reduction in availability and higher cost at the riskier end of the credit spectrum. Alternative arrangements are therefore needed for financing of risky exposures if a fall in economic growth is to be avoided. In this context securitisation (broadly defined to include all forms of bank sponsored collateralised instrument, including covered bonds) will be of central importance. Re-establishing securitisation markets on a sounder footing appears essential, in order both to prevent a renewed credit contraction and to help prevent riskier borrowers from being cut off from credit. The shifts in bank balance sheets will also require substantial portfolio adjustments amongst long term institutional investors, from short term to long term debt and from debt to equity. The associated adjustment of both market prices and required returns can be accommodated but poses a substantial co-ordination problem and could take a long time. Finally the new liquidity rules could create new unintended systemic risks. In particular the proposed definition of eligible liquid assets is dangerously over-concentrated on government debt. The definition of should be broadened to give banks more scope to hold liquidity in the form of commercial claims; and central banks should clarify in what circumstances they will provide emergency liquidity assistance.