Will new banking rules slow global economic growth?

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In one of the most significant reforms to global finance to emerge from the Great Recession, regulators from around the world agreed to new standards for banks on Sunday, called Basel III. The rules are aimed at making the world’s financial system safer and less susceptible to the sort of recession-inducing meltdown we endured in 2008 by requiring banks to maintain stronger balance sheets. Here’s how the Federal Reserve and two other U.S. agencies put it in a joint statement:

The agreement represents a significant step forward in reducing the incidence and severity of future financial crises, providing for a more stable banking system that is less prone to excessive risk-taking, and better able to absorb losses while continuing to perform its essential function of providing credit to creditworthy households and businesses.

Sounds nice, doesn’t it? But there are a couple big questions hanging over Basel III, questions that will have an impact on all of us. The biggest one could well be: Do safer banks mean slower economic growth?

The heart of Basel III is an increase in the minimum amount of core capital – called “common equity” – a bank will have to maintain relative to its assets. And it’s a hefty hike, from 2% to an effective 7%. Banks that have more capital on hand can more easily absorb losses, making them better equipped to withstand crises and less likely to go hat in hand to taxpayers for bailouts.

But on the other side of the equation, a less desirable effect may also be the reduced availability of credit. The concern is that the world’s banks will be constrained in the amount of loans they can make and risks they can take. That might mean we’ll have a harder time getting loans to buy houses and cars, or to build factories and create jobs. Or perhaps we’ll have to pay higher interest rates to get those loans, which increases the costs of borrowing and dissuades investment, again costing jobs. Credit is the lubricant of economies, and less of it could result in less growth.

How realistic is this fear? The fact is that there is a widely held belief that stricter bank rules will likely mean a slower global economy. The question is by how much, and more philosophically, do the benefits of safer banks outweigh that cost?

There has been a wide range of opinion on the impact Basel III could have on growth. Back in June, the Institute of International Finance, a global association of banks, issued a report claiming that the GDP of the United States, the Eurozone and Japan would be 3% lower by 2015 with the new rules in place than it would otherwise have been. The institute went on to estimate that about 9.7 million fewer jobs would be created as a result. But other estimates are far less terrifying. In a study in July, Douglas Elliott, a fellow at the Brookings Institution, argued that significantly higher capital requirements would have “little effect on availability” of loans, while any increase in loan pricing would be miniscule and therefore “would likely have quite minimal effects on economic growth.” Granted, these studies were both conducted before these Basel III rules were finalized, but they give us an idea of just how wide a gap there is on the subject of banking regulation and growth.

Of course, with the global recovery so tepid and unemployment so high, it’s tempting to say – let’s not take the chance Basel III will dampen growth even further and put the whole reform on hold. But in my opinion, the new banking rules are worth the risk. First of all, I don’t buy into the more dire scenarios of greatly reduced global welfare as a result of tighter bank regulation. Ultimately, banks make money by making loans, and I find it hard to believe that a sound investor or prospective homebuyer won’t be able to find a loan at an affordable rate, whatever a bank’s capital requirement might be. Also, the new rules are being implemented very, very slowly to minimize the potential impact on the overall economy. Though some changes take effect in 2013, others won’t until 2019. That gives banks an awful long time to get their houses in order.

And more fundamentally, after seeing the devastation caused to lives, jobs and incomes by a financial crisis created by bankers who gorged on risk, perhaps a world with a little less risk – and potentially a little less growth – is better for everybody.

But that leads to the second big question: Will Basel III work? Will the new rules produce a well-functioning banking sector that is less vulnerable to risk-induced catastrophes? The fact is that Basel III won’t change the way in which banks actually work. They can still invest in high-risk assets if they so choose. And determining what is and is not a risky asset is not always so easy. Many toxic assets are only toxic with hindsight. Remember, most bankers thought those subprime mortgage-backed securities were risk-free. The horror scenario here is that we end up with a world with slower growth and a global financial system still prone to the kind of shenanigans that can lead to more Great Recessions. That possibility puts extra pressure on the world’s regulators. Here’s how The Financial Times put it in an editorial the other day:

The conditions remain in place for another bubble to inflate. Bankers show little sign of modifying their behavior voluntarily. Having come through the crisis intact, they doubtless don’t see the point. Moreover, they are resisting efforts to rein in their activities, especially if these involve structural changes…All this places a huge importance on the new international capital standards for banks, and the performance of regulators in implementing them…Regulators may have been given greater authority to keep banks on a tight leash. But they must actively enforce their new powers. To do this, they must have the political backing to make enemies of the banks.

In other words, new laws are only as good as the people who implement them. What impact the Basel III rules will have on the world economy will very much depend on what we end up doing with them.