U.S. and international regulatory reform efforts have taken the important steps of increasing the quantity and quality of capital required of banking institutions, and U.S. banking organizations have since the crisis significantly increased the amount of capital they hold. The benefits of sufficient capital are widely recognized, but there is a significant under-appreciation of the trade-offs between higher capital requirements and the associated impact on banks’ cost of funding and lending activity. Recent evidence from UK banks’ efforts to meet heightened capital requirements demonstrates that a 10% increase in the capital ratio requirement resulted in a 9% contraction in the supply of bank credit.¹ Given their potential costs, capital requirements should strike a balance between the mutually important goals of enhancing bank stability and fostering economic growth.

The costs of higher capital requirements can include: Higher lending rates / decrease in lending activity for banks, Migration of financial activity to the shadow banking sector, and Potential long-term output loss / decline in growth.

Douglas Elliott of the Brookings Institution explains that “[h]igher bank capital requirements are likely to result in higher interest rates on loans, lower rates on deposits, and reduced lending.” Heightened capital levels “increase the total expense of operating a bank and making loans, even taking account of the decrease in the cost of each dollar of bank equity and debt due to the greater safety of a bank which operates with more capital.”²

The primary cost of a sudden increase in capital requirements is reduced banking activity, especially reduced lending. Since a capital requirement is a ratio of capital to risk-weighted assets, banks have an incentive to increase capital and to reduce assets (i.e. reduce lending).³

Increased capital requirements can also have financial stability implications. An IMF Working Paper finds that increased capital levels “could create significant incentives for regulatory arbitrage and a shift away from traditional banking activity to the ‘shadow-banking sector.’”⁴ Similarly, a paper co-authored in 2010 by Jeremy Stein cautions policymakers that increased capital requirements will “drive a larger share of intermediation into the shadow-banking system” and that “careful attention must be paid to not tilting the playing field in a way that generates a variety of damaging unintended consequences,” including making the overall system of credit creation less safe.⁵

To the extent that financial activity does fully not migrate to the shadow sector, it is possible that decreased lending by banks can lead to long-term output loss. Recognizing these dynamics, UK regulators have recently stepped back from steep increases in capital requirements in an effort to avoid an associated drag on growth.⁶ Their decision reflects a consideration of the empirical evidence illustrating that increased capital requirements impact both the soundness of individual banks and broader economic and stability concerns, especially during times of economic recovery.

¹ Calomiris et al., “Does Macro-Pru Leak? Empirical Evidence from a UK Natural Experiment,” November 2011.
² Elliott, Douglas, “A Primer on Bank Capital,” January 28, 2010.
³ Calomiris, Charles, “How to Regulate Bank Capital,” National Affairs, Winter 2012.
⁴ Cosimano, Thomas and Dalia Hakura, “Bank Behavior in Response to Basel III: A Cross-Country Analysis,” May 2011.
⁵ Hanson, Kashyap, and Stein, “A Macroprudential Approach to Financial Regulation,” July 2010.
⁶ “FSA eases bank rule to boost lending,” Financial Times, October 9, 2012.