April 16, 2011

Financial Regulation, Economic Growth and the Effects of the Basel III Regulatory Framework

Financial industry leaders and free-market advocates have argued that the Basel III capital requirements regulation will have a significant impact on banks operations. The general expectation is that the regulation will generate a large contraction in lending activities that will ultimately result in a negative impact on economic growth.

In economics, the relationship between a highly developed financial system and economic growth has been a central topic for economic research. In the early stages of macroeconomic studies, many economists observed that there is a positive correlation between a large financial system and GDP growth. The idea is that a well-developed financial system will foster lending to productive activities, acting as an engine for economic development. However, other economists argue that the causal relationship between the variables is not clearly established, debating that a large financial system will only develop as a consequence of economic progress.

In a more recent set of academic articles there has been an attempt to establish a causal link between financial development and economic growth. There is now sufficient scientific evidence to say that a large financial system plays a crucial role in economic development. However, with the recent financial crisis, the academic community has become skeptical about the true nature of the causal link between finance and economic growth. For example, many economists from the US are studying the financial crisis observing that when the financial sector becomes disproportionally large compared to other productive sectors in the economy, the causal relationship that goes from financial development to economic growth is no longer sustained. Furthermore, it is empirically clear from the financial contagion triggered by the subprime mortgage crisis, that the effects of modern financial innovation (securitization practices) can have a devastating impact that transcend national boundaries and affect the global economy.

In the light of the recent financial crisis and in an attempt to make the international financial system safer, the Basel Committee for Banking Supervision established (in July, 2010) the normative for target ratios and capital requirements to which banks must comply to maintain sustainable risk levels. Also, it established the timeline to reach the specific liquidity and risk management requirements desired under the Basel III regulatory standards. The impact of the regulation is to be expected substantial and to significantly affect the functioning of the international financial system. In particular, it is expected that the ROE of European Banks will decrease up to 4.5% from its pre-crisis level of 15%. Also, it is believed that European Banks will compensate by decreasing costs in the form of layoffs that would further impact the macroeconomic balance of the EU. Cost rises may be expected to pass on to customers as expensive banking services and increased funding costs. Economically speaking, the total expected impact of Basel III implementation on GDP growth is about -0.15% annually.

On the other hand, the long run socio-economic impact of the Basel III normative is seen as positive. In the short run, it is expected that the lending spreads could increase by 6 basis points for each 1% increase in the capital ratio requirements, assuming that banks will level their ROE at 10%. Nonetheless, the potentially catastrophic effects of a new financial crisis are many times higher that the short run effects of higher costs of funding. In fact, a financial crisis can permanently deviate GDP growth from the trend and the economy may not be able to recover or catch up to the previous direction in the short run. Banks on the other hand, have more pessimistic side of the story and argue that smaller banks will significantly suffer from the regulation and pay for the wrongful doing of large multinational investment banks. Furthermore, the financial industry has argued that the new capital requirements will deeply affect bank profits and lead to a reduction of lending with negative consequences to the economy. While it is not certain that higher capital ratios will decrease banks profits, most economists agree on the fact that is most necessary to establish regulatory mechanisms in order to avoid a new financial crisis that could severely damage the global economy.

The general consensus agree on the fact that a solid financial regulation framework that ensures that no financial player has sufficient risk to put in jeopardy the whole system, is necessary to avoid over speculation and poor risk assessment. Under such a view, the long term safety and stability of the financial system more than compensates for the short run costs of regulatory implementation and the slowdown in GDP growth.


Arcand, JL, E Berkes, and U Panizza (2011), “Too Much Finance?”, unpublished.

McKinsey & Co. (2010), "Basel III and European banking: Its impact, how banks might respond, and the challenges of implementation"