Empirical evidence of Basel’s capital misallocation

Some old-time readers perhaps remember what I called the ‘RWA-based ABCT’ (RWA for risk-weighted asset, and ABCT for Austrian Business Cycle Theory). RWAs, defined by Basel banking rules, represent the capital ‘price’ of each asset class held on a bank’s balance sheet. The classic ABCT represents a monetary policy-induced boom, during which interest rates are below their natural rate, misleading entrepreneurs into believing that borrowing for long-term projects will pay off. But, as savings haven’t actually increased, there is an intertemporal discoordination between entrepreneurs and savers’ expectations, leading to systemic misallocation of capital, eventually resulting in a bust as projects cannot be completed or turn out to be loss-making.

I have always argued that a regulation-induced boom could also trigger a relatively similar capital misallocation and boom-bust cycle. To sum up, Basel rules have fixed bank’s capital price low for a number of asset classes (which all boomed over the decade before the financial crisis, coincidentally…) and high for some others (which have been chronically starved of funds, coincidentally…). One of these asset classes that were deemed risky enough to get penalized by regulators is also one of the most crucial for the economy: SME and business lending.

I was recently made aware of two different papers actually criticising this Basel framework for being too harsh and unnecessarily harming SMEs. One of them, published last October by Bams, Pisa and Wolff, studied the US market and is titled Credit Risk Characteristics of US Small Business Portfolios (see the related VoxEU article here, or a pdf presentation summary here).

They find (incredibly important paragraph; read it twice, or perhaps three times if necessary):

that small businesses are subject to inefficient capital allocations imposed by the regulator. The results show significant discrepancies in capital requirements implied by Basel II and the proposed model. For all levels of credit worthiness of the obligor, the Basel II formula significantly overstates the asset correlations and thus the capital requirements for sub-portfolios of small businesses, which is shown by the highly significant paired difference test. Indeed, we observe that the capital requirement is on average almost four times higher than the data suggest. And it is the more creditworthy obligors that suffer the highest capital charges relative to their riskiness. For these firms the regulatory formula overestimates the capital requirement even by factor of about ten. As a result these more creditworthy obligors pay for the credit risk of their less creditworthy peers. It also creates inverse incentives for financial institutions, which may flee to other obligor classes in which loans originated are less costly to hold.

Now just try to imagine the cost that Basel has been to our economy… They also find that large corporate benefits from more relax capital requirements relative to SMEs. Although I have to add that even large corporates are inefficiently penalised relative to some other exposure types such as real estate and sovereign. Therefore, the capital treatment differential between SMEs and real estate is very large. It shows the secular stagnation story into a different perspective.

But that’s not it. An older (2013) Deutsche Bundesbank piece of research that I wasn’t aware of also found remarkably similar results in Germany (Evaluation of minimal capital requirements for bank loans SMEs, by Dullmann and Koziol).

They do acknowledge that RWAs affect banks’ profitability, and hence capital allocation:

Since regulatory capital requirements can affect the interest margins required by the lender, only their appropriate calculation in the sense that they reflect the actual risk posed by the borrower will ensure an optimal credit supply for the economy. Since SMEs are the backbone of the economy in many countries, such as Germany, appropriate capital requirements are crucial for economic growth.

After looking at a portfolio of German firms and their default rates, they estimate the asset correlation, and therefore potential capital buffer that would be required to absorb unexpected losses of a portfolio of such firms. They come up with a number of tables (such as the one below) showing the capital requirements differences between their estimates and Basel’s requirements.

As in the US, they found that Basel systematically overestimate the capital required to absorb SME-linked losses.

They conclude:

In our paper we have identified two cases in which our empirical results suggest that the relative differences between the capital requirements for large corporates and those for SMEs (in other words, the capital relief for SMEs) are lower in the current regulatory framework than implied by our empirically estimated asset correlations.   Since these average total differences reflect the capital relief granted for SMEs by the regulators they may indicate { in certain cases and if taken at face value { a potential for increasing this capital relief. This would be equivalent to lowering the regulatory capital requirements for SMEs, for instance by lowering the asset correlation values in the IRBA formula or by lowering the RSA risk weights directly.

In short, we now seem to have empirical evidence that the Basel ruleset leads to a systemic inefficient capital allocation across the economy, with a number of sectors unnecessarily suffering (and others booming instead). Of course the results of those two studies might not apply to all countries that have implemented Basel. But the US is the largest economy in the world, and Germany the largest in Europe, so any misallocation of capital has much broader repercussions.

HT: Stefanie Schulte