UK bank capital rules: Modest short-run costs, long-run stability
A Bank of England working paper finds that higher bank capital requirements in the UK entail negligible long-run costs, despite modest short-run macroeconomic effects. The study indicates banks primarily adjust by reducing risk-weighted assets rather than raising new equity.
Capital adjustments and economic impact
The study, employing a structural VAR framework with sign and narrative restrictions, reveals how UK banks respond to prudential capital changes.
Impulse responses indicate that institutions primarily adjust by reducing risk-weighted assets rather than raising new equity.
While higher capital requirements involve negligible long-run costs, modest short-run macroeconomic effects are observed, consistent with other VAR studies.
These impacts are driven by a contraction in lending and an increase in spreads across various sectors.
The paper also highlights state-dependent effects, where altering capital requirements during recessions amplifies short-run contractions, though these effects are more short-lived with quicker output recovery.
Indicators of market power suggest tighter capital requirements temporarily reduce banking competition.
Balancing stability and short-term costs
The paper contributes to the debate on balancing long-run financial stability benefits of strong bank capitalisation against potential short-run economic costs.
Post-global financial crisis, macroprudential reforms like stress tests highlighted the importance of sufficient bank capital.
While evidence consistently shows positive net present value for capital requirements, banks' actions to meet these can impose temporary costs, such as reduced lending and increased rates.
The study aims to quantify these economic costs to inform policy design, addressing macroeconomic feedback loops and supervisory-driven capital shocks.
Timely insights for prudential policy
This Bank of England working paper provides crucial empirical evidence for the UK context, bridging micro-level identification with macroeconomic dynamics.
Its state-dependent analysis offers valuable insights for calibrating macroprudential interventions, especially during economic downturns.
The findings reinforce the long-term benefits of robust capital, despite temporary adjustments, making it a key input for future policy considerations.