Basel capital requirements and mortgage pricing

Do we still need evidence that Basel’s capital requirements distort interest rates and capital allocation in the economy? Yes we do. We need as much evidence as we can in order to present a bulletproof case against current banking regulation.

I have argued since this blog’s inception that the pricing distortions hardwired in Basel’s framework led to fundamental misallocations that could trigger economic crises (the ‘RWA-based ABCT’) and progressively provided empirical evidence in support of this case. Just a few weeks ago, I reported that recent (and not so recent) pieces of research were (unsurprisingly in my opinion) attacking Basel on the ground that it unnecessarily penalised SME lending.

This post is the first of a series of three new short posts covering research papers published over the past few months which, you guessed it, seem to add to this growing body of evidence.

The first one, titled Higher Bank Capital Requirements and Mortgage Pricing: Evidence from the Countercyclical Buffer (CCB), is also the first paper I read that shows that macro-prudential regulation could have some effect! Although this effect is limited and it is unclear (and uncontrolled) if credit growth cannot happen through other channels.

But what I’m interested in is the impact of the countercyclical buffer (CCB), a macro-prudential tool that allows policymakers to adjust capital requirements according to where in the economic cycle they believe we stand. It’s all discretionary and they will often get it wrong (assuming they are not influenced by politics) of course, but at least it allows us to live test the reactions of private actors to this exogenous constraint and measure the resulting distortion in credit supply and pricing.

In this case, Switzerland raised the CCB for mortgage lending only, leaving other sorts of lending untouched, which effectively tightened the spread between mortgage capital requirements and the rest. Remember that mortgage (or sovereign) lending benefited from much lower capital requirements than corporate lending, making it more profitable at equal levels of risk to extend credit for real estate purposes. In theory, and given a fixed money supply, this incentive should lead to increased mortgage supply and lowered interest rates on mortgage products. Hence, a reduction in the capital differential would likely reduce the supply of mortgage and/or raise interest rates.

So what did the paper find? That the CCB was changing the composition of mortgage supply and raising mortgage interest rates:

Results […] point out that capital-constrained banks raise their rates relatively more after the CCB’s regulatory shock than do their unconstrained peers. In line with the joint estimation, these constrained banks now charge on average 2.72 bp more which reflects their tradeoff between approaching the now even closer intervention threshold and additional profits. The constrained indicator is not statistically significant in either estimation.

Results […] reveal that banks that specialize in the mortgage business increase their mortgage rates after the CCB activation by on average 5.57bp relative to non-specialized competitors. Higher capital requirements force banks to hold more equity capital for each mortgage already on their balance sheets. Some of that additional cost on their existing portfolio is passed on to new customers. Again, the specialized indicator is insignificant in both regressions

This is encouraging evidence, although not comprehensive. It would have been interesting to find out whether or not other sorts of lending benefited from changes in their supply and/or pricing.

Regarding the conclusion that the CCB might be an effective macro-pru tool, the paper did not control for domestic or international leakage (i.e. credit growth through other channels) and it remains to be seen whether or not banks are not willing to go down the risk scale in order to extract higher rates for the same amount of capital (which would come at the expense of financial stability down the line).