Macroeconomic cost-benefit analysis of Basel III minimum capital requirements and of introducing deposit guarantee schemes and resolution funds

The present work proposes a new methodology to estimate the reduction in the probability of occurrence of a systemic banking crisis entailed by the implementation of the Basel III framework for banking regulation. This is achieved by making use of the SYMBOL model (SYstemic Model of Banking Originated Losses) jointly developed by the JRC, DG MARKT, and experts of banking regulation (see De Lisa et al., 2010) that estimates, given Basel capital requirements, the losses and liquidity shortfalls deriving from banks' defaults. A systemic banking crisis is defined in this work as a situation where liquidity shortfalls are higher than a certain threshold, beyond which public authorities would find it difficult to intervene by injecting liquidity and therefore would have hard time in trying and avoiding that the crisis spreads further. In particular, we assume that the threshold for a systemic banking crisis in any country corresponds to 3% of its Gross Domestic Product (GDP). Given this definition, the probability of a systemic banking crisis is derived from the distribution of liquidity shortfalls affecting the banking system due to banks¿ default. The reduction in the probability of a systemic banking crisis deriving from the adoption of Basel III is obtained by running the SYMBOL model under alternative scenarios for banks' capital, in particular considering the estimated change in banks' capital requirements induced by Basel III. The macro-economic impact of implementing Basel III is also estimated coupling the results of the SYMBOL model with a cost-benefit framework proposed by the Bank of England (2010), which estimates the net gains of tightening capital requirements as a percentage of a country's GDP. Benefits arise from the expected fall in GDP (that follows a banking systemic crisis) avoided thanks to a reduction in the probability of having a systemic banking crisis; costs derive instead from the increase in lending rates introduced by banks as a reaction to the tighter Basel III capital requirements that in turn induce a decrease in nonfinancial firms¿ investments and a drop in GDP. The proposed approach is applied to representative samples of banks from a few European countries: France, Germany, Ireland, Italy, Spain, and the United Kingdom. Our main results are as follows: first, regarding the effect of Basel III on the probability of a systemic banking crisis, we find that its reduction considerably depends on the initial level of banks' capital and on the level of recapitalization of banks that follows the implementation of Basel III; second, regarding the macro-economic impact of Basel III, we find that the net benefits of implementing Basel III are always positive and almost always larger in the scenario where the capital conservation buffer is introduced.