The Impact of Bank Capital Regulation on Financing the Economy

The Global Financial Crisis as well as the Eurozone Banking and Sovereign Debt Crisis revealed deficiencies in bank capital regulation which made banks vulnerable to stress in interbank markets as well as to stress in sovereign debt markets. Deterio-rating banks’ balance sheet quality weakened the loan supply. Especially loans to small and medium-sized enterprises within the EU became restrictive. Among re-forming bank supervision, the European Commission strengthened bank regulation by applying the Basel III recommendations to European law in form of the Capital Requirements Regulation (CRR) and the Capital Requirements Directive IV (CRD IV). A public consultation on the effects of CRD IV and CRR is taking place until October 7th of this year.

We recommend the Commission to follow a balanced approach to bank regulation which ensures both financial stability and a well-functioning loan supply for firms and households. Thereby bank regulation should acknowledge that banks, which are specialized in financing small and medium-sized companies and banks specialized in long-term financing face lower risks compared to banks which are heavily exposed to their home-countries’ sovereign debt or which are specialized in trading assets. Therefore, capital regulation should ensure sufficient capital buffers for trading activities and other more risky short-term activities, while it should not be too restrictive to bank activities, which are of a more long-term and low-risk nature: (1) For banks, which are specialized in low-risk activities, like lending to small and medium-sized companies or lending for infrastructure projects, raising equity capital in financial markets is more expensive. The leverage ratio might be too restrictive to these banks and leads them to reduce their long-term financing of the economy. (2) The Net Stable Funding Ratio (NSFR) is a response to the crisis experience that banks, which were less capitalised and which relied too heavily on short-term wholesale funding, had to sell-off assets at fire-sale prices as market liquidity froze. Since this requirement is calibrated to a stress scenario, it might be too restrictive in normal times for banks which are specialized in long-term financing. (3) The European Banking and Sovereign Debt crisis revealed that sovereign debt is far from riskless and far from liquid in times of stressed sovereign finances and that some banks are too heavily exposed to their home-country’s sovereign debt instruments. EU sovereign debt exposures should therefore be treated like exposures to private entities according to their underlying risks. Besides increasing the safety of banks, the abatement of the preferential treatment of sovereign debt would level the playing field between lending to firms and lending to sovereigns, and thereby improve access to finance for small and medium-sized companies.