Capital requirements and loss absorption capacity for large banks: Systemic risk and growth

Giorgio Barba Navaretti, Giacomo Calzolari, Alberto Pozzolo

08 July 2015

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The debate on capital requirements and loss absorption measures for large banks is to a large extent about something quite specific – the presumed trade-off between hedging systemic risk and expanding lending to the real economy. The first issue of European Economy - Banks, Regulation and the Real Sector  – a new online journal to encourage informed and fair exchanges among academics, institutional representatives, and bankers – is devoted to disentangling this debate and discussing its key ingredients.

All regulatory reforms introduced in the aftermath of the Global Crisis have been aimed at strengthening banks’ balance sheets. To a large extent, these reforms aim to reduce leverage and increase capital buffers. On top of these requirements, regulators are identifying classes of liabilities that can be explicitly targeted in terms of their loss-absorbing capacity in order to bail-in banks in distress (instead of leaving their bail-outs to other players, such as taxpayers).

Extra requirements have been imposed on globally systemically important banks (GSIBs), justified by the systemic dimension of their activities and by the moral hazard concern implicit in the ‘too big to fail’ argument, i.e. the presumption that taxpayers’ funds would always be at hand to bail out systemically relevant financial institutions.  An especially significant and sizeable measure targeted to GSIBs is the so-called total loss absorbing capacity (TLAC), still under discussion at the Financial Stability Board.

How effective are additional capital and loss absorption requirements in reducing systemic risk? What is their impact on lending to the real economy and on economic growth? Is the bail-in principle even effective in enhancing the resilience of banks and reducing the occurrence of bailouts with taxpayers’ funds?

These are not straightforward questions to answer, as the first issue of European Economy – Banks, Regulation and the Real Sector highlights.

The aim of equity capital requirements and of the other liability-related bail-in methods is essentially to create buffers that are capable of absorbing losses and increasing the resilience of banks during distress. Frequently, the banking industry and other commentators have challenged capital increases on the grounds that these would have forced banks to reduce lending and total assets so as to meet regulatory capital ratios. The extent to which this trade-off is effective has been hotly debated, as has its very nature. Its very existence has been put into question by some. Others, at the opposite side of the spectrum, have taken the negative impact of capital requirements on lending for granted.

We believe that the nature and the extent of this trade-off rests on a large number of details:

  • The timing of implementation;
  • The size of capital requirements;
  • Risk weighting provisions;
  • The definition of eligible capital instruments; and
  • Market frictions.

Moreover, given that requirements are the outcome of several layers of frequently overlapping and sometimes inconsistent regulations, this detailed web of ideas is fairly tangled.

Indeed, while all contributors to the journal agree that capital requirements and loss absorption measures are necessary tools for achieving financial stability, according to most of them, these are also imperfect tools, and under several circumstances they may indeed hinder growth. For this reason, the specific provisions and the design of these measures must be assessed and understood carefully, weighting their costs and their benefits.

About  European Economy – Banks, Regulation and the Real Sector

This new online journal encourages an informed and fair debate among academics, institutional representatives, and bankers about banking regulation and it effects on the real economy. The journal is published by Europeye, a publishing company with Unicredit Group among its shareholders. Its editors and advisory board operate under an agreement of full independence.  

The journal aims to be an outlet for research- and policy-based pieces, combining the perspective of academia, policymaking and operations. Special attention will be devoted to the link between financial markets and the real economy and how this is affected by regulatory measures. Each issue concentrates on a current theme, giving an appraisal of policy and regulatory measures in Europe and across the world.

Editors: Giorgio Barba Navaretti (University of Milan), Giacomo Calzolari (University of Bologna), Alberto Franco Pozzolo (University of Molise).

Advisory Board: Elena Carletti (Bocconi University); Guido Ferrarini (University of Genova); Alberto Giovannini (Unifortune); Ralph de Haas (EBRD); Ivan Lo Bello (Confindustria); Gianmarco Ottaviano (LSE); Jean-Charles Rochet (University of Zurich); Salvatore Rossi (Bank of Italy); Dirk Schoenmaker (VU University, Amsterdam); Nicolas Véron (Bruegel and Peterson Institute).

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Topics:  Financial regulation and banking

Tags:  “capital requirements”, “systemic risk”, lending

Professor of Economics at the University of Milan and Scientific Director of the Centro Studi Luca d’Agliano

Professor of Economics, Bologna University ; Research Fellow CEPR

Professor of Economics at the University of Molise

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