WASHINGTON - New York Federal Reserve Bank President William Dudley downplayed the economic impact of the higher capital standards that will be phased in in coming years under a recent international agreement reached in Basel, Switzerland in a Sunday morning speech.
Dudley, in remarks prepared for the Institute of International Finance, said the potential costs of the more demanding "Basel III" capital requirements has been "exaggerated." He also doubted whether they will force banks to increase lending spreads as much as some have predicted.
He said the new capital accord strikes the right balance between the needs for large financial institutions to have a stronger capital base and the needs of the economy for credit.
"Some argue that the new standards are too severe," Dudley noted. "They argue that, in the short run, the higher standards could lead to a significant constraint in credit that could hurt the nascent economic expansion. And, they argue, in the long run, that the higher capital standards will inevitably drive up lending costs and that this will hurt economic performance."
Dudley demurred. "Although I believe the new standards do impose some real costs on the financial system in order to achieve real benefits, I believe that concerns over the costs are exaggerated."
He said he "cannot precisely predict the size of the adjustment costs as they will depend importantly on the strategies bank managers employ to meet the new requirements, and how bank investors respond to these actions."
"Nonetheless," he added, "I believe the transition is likely to be quite manageable for three reasons:
-- "First, many of the large U.S. banks already have large amounts of tangible common equity" as a result of last year's "stress tests" on the 19 biggest banks.
-- "Second, ... the standards are being phased in slowly. For example, in 2013, the tangible common equity standard will be only 3.5%. In 2013, there will be no conservation buffer requirement and banks will still get credit for items that will ultimately be deducted from common equity, such as deferred tax assets....
-- "Third, banks have many ways they can adjust their business models to meet the new standards as they are phased in. Many of these changes can occur without any risk of disruption to the flow of credit to households and business. For instance, banks can sell non-strategic assets to investors and can modify their minority investments in non-consolidated interests."
Dudley said he "expects" that banks will ultimately meet or exceed the 7% common equity limit, which is the sum of the minimum requirement and a "conservation buffer."
But he said, "we do anticipate that the buffer may be penetrated from time to time during adverse economic environments."
Dudley also addressed concerns that Basel III could cause banks to widen lending spreads -- the difference between their cost of funds and their lending rates -- to generate additional capital. He didn't dispute that this will happen, but suggested that the spread widening will not be large.
"It would be prudent to assume that requiring banks to hold more capital and higher cost capital is likely to result in somewhat higher lending spreads," he acknowledged. "Bank managements will need to generate sufficient income to support the rate of return on equity at a sufficient high level so banks can continue to attract capital from investors."
But he said "those who argue that the new capital standards will necessitate a large increase in lending spreads generally start with a rigid set of assumptions."
Those betting on large increases in spreads assume 1. "return on bank equity is unchanged; 2) the increase in bank equity does not affect funding costs; and 3) there is no change in the banks' book of business or on banks' ability and willingness to adjust other expenses, such as compensation."
Dudley said "such rigid assumptions are unrealistic" and said "this is particularly important because each assumption is likely to be wrong in the direction that reduces the impact on lending margins."
"First, the necessary return on equity that banks will have to generate to be able to attract capital will likely fall," he said. "Because banks with more capital should be safer and have less volatile earnings, investors should demand a lower return on equity than before."
"Second, by increasing the soundness of banks, an increase in bank equity, everything else equal, should also reduce funding costs," he contended. "Third, higher bank lending spreads almost certainly will push some activity into the capital markets, constraining the magnitude of the rise in total lending costs."
"Finally, banks may be forced via competitive pressures to lower their compensation levels," he continued. "By cutting compensation costs, banks could have smaller lending margins and still earn sufficient profits to generate a level of returns necessary to attract capital."
"Given all the potential margins for adjustment, there are good reasons to expect that the increase in lending margins will actually turn out to be quite modest," he added.
Dudley conceded that "any increase will be a real cost," but he said "this appears to be a necessary and appropriate price to pay for a much more resilient financial system."
"The cost represented by higher lending spreads has to be weighed against the benefits of a more robust and resilient banking system," he said.
Dudley said "the biggest lesson of the financial crisis is that severe financial disruptions can inflict very large and persistent costs on real economic activity and employment." And so "lawmakers and regulators must make widespread changes to create a more resilient and robust global financial system."
"But, at the same time, this must be done in way that ensures the financial system retains sufficient dynamism so that it can allocate capital efficiently to support innovation and economic growth," he said.
The Basel III capital and liquidity standards accomplish this goal, according to Dudley.
"I believe these standards address some of the major shortcomings revealed by the crisis," he said. "The new standards will require banking organizations to significantly increase the amount of high-quality, loss-absorbing capital that they hold; significantly improve risk capture in trading, counterparty credit, securitization and other activities that the prior regulatory capital requirements did not adequately capture; make it more expensive for banks to provide liquidity guarantees to shadow banks; constrain the leverage that banking companies can take by introducing a credible, non-risk-based backstop; and increase the capacity of banks to absorb shocks that might temporarily impede their ability to access short-term funding markets."
Dudley said the agreement "achieves an appropriate balance between significantly increasing the minimum capital and liquidity requirements for the major banks, while doing so in a way that recognizes the current state of the global economy and that seeks to minimize adjustment costs."
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