Networks Financial Institute at Indiana State University Releases Policy Brief -- "Will Changes to Bank Capital Requirements Affect Competition?"
(January 25, 2006, Indianapolis, Ind.) – A new Policy Brief published by Networks Financial Institute at Indiana State University (NFI) addresses whether proposed changes to the so-called Basel I capital requirements will mitigate a competitive advantage for banks operating under the new “Basel II” capital requirements. The brief “Would Proposed Changes in Basel I Capital Requirements Mitigate Competitive Inequalities Created by Implementing Basel II?” was authored by R. Alton Gilbert, senior fellow at NFI.
The Policy Brief examines how proposed changes to Basel I capital requirements would impact competition between large and small banks. The policy brief further proposes that competitive equities could be achieved by requiring larger banks to continue to maintain leverage ratio constraints. Gilbert argues that leverage ratio constraints would allow bank supervisors to limit the amount by which banks operating under Basel II could reduce their capital ratios.
For nearly 20 years, supervising agencies of both large and small banks in developed nations have set capital requirements based on the Basel requirements established in 1988 in Basel, Switzerland. The introduction of Basel II capital standards, which will only apply to very large banks with sophisticated international operations, raises concerns that smaller banks will suffer a competitive disadvantage. An analysis conducted by the Federal Reserve staff and published in The American Banker, November 14, 2005, indicated that 13 of 26 large banks surveyed would be able to reduce their capital requirements by at least 26 percent under Basel II.
Concerns over unfair competition prompted U.S. supervising agencies to release for public comment several proposed changes to Basel I capital requirements. Gilbert’s Policy Brief notes that many of the Basel I proposals are not very specific and that their effectiveness in mitigating competition is likely to be ambiguous. He points out that the proposed changes in Basel I capital requirements rely on changes to risk weights that will mitigate competitive inequality only if they successfully reduce required capital. To illustrate the potential impact, the article considers how changes in Basel I might affect competition in various capital requirement scenarios.
The scenarios presented examine how a bank’s capital requirements will affect its risk mix and lending capabilities, particularly for small and medium enterprises. It concludes that under Basel II, large banks will still enjoy an advantage when competing in the small and mid-sized lending environment. Larger banks will also enjoy economies of scale competing in the low-risk mortgage and residential mortgage origination markets.
Beyond the competitive environment, Gilbert’s article addresses how proposed changes in Basel I capital requirements would affect banks’ capital levels. He addresses the function of minimum capital requirements set by supervisors and differentiates between the Risk-Based Capital Requirements and the Leverage Ratio. The Policy Brief urges readers and policy makers to recognize the important distinction between adequately capitalized vs. well capitalized and that careful interpretation of a bank’s classification and the two different capital constraints are significant for determining the impact of proposed Basel I changes.
The briefing examines how the leverage ratio constraint compares to the capital requirements based on risk-weighted assets for a number of banks of various sizes. Gilbert concludes that changes in weights used in calculating risk-weighted assets would not be relevant for mitigating competitive inequalities created by Basel II for at least one- third of smaller banks. Gilbert concludes that if bank supervisors retain the current leverage ratio constraint for smaller banks, changing the weights used in calculating risk-weighted assets will not mitigate the competitive inequalities brought about by Basel II. Gilbert argues that keeping the leverage ratio constraint for Basel II banks is critical for mitigating the competitive effects of Basel II. He explains that the widely expected significant reductions in capital requirements for Basel II institutions will be avoided if these banks are held to the leverage ratio constraint. The leverage ratio constraint also sets a tight upper limit on the amount by which the largest U.S. banks could grow their assets under existing capital.
Networks Financial Institute at Indiana State University was founded in 2003 with a grant from Lilly Endowment Inc. NFI strives to facilitate broad, collaborative thinking, dialogue and progress in the evolving financial services marketplace, concentrating on the areas of education, outreach and research. Headquartered in Indianapolis with offices in Washington, D.C. and on the campus of Indiana State, and with outreach internationally, NFI’s goal is to serve as a catalyst for change in the financial services industry.
R. Alton Gilbert is a Senior Fellow at Networks Financial Institute. Gilbert previously was Vice President and Banking Economics Advisor at the Federal Reserve Bank of St. Louis. His major research interests include the effects of regulation on financial institutions, specifically microeconomic effects and implications for macroeconomic policies.
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