Basel III: Mapping the effects to stability, output and lending in the Nordics

Martin Mikael Lilius

Student thesis: Master thesis

Abstract

The study begins by establishing the background for the study by laying out the basic premises that govern financial regulation, and thus the Basel framework; the promotion of consumer welfare and institutional stability, correction of negative externalities and market failures. Achieving these basic objectives in an efficient manner is believed to create more benefits than costs to the society at large, and this belief that the financial system and the economy may benefit from good regulation is the justifying argument for financial regulation at the most basic level. After this background is established, both Basel II and III frameworks are covered to map out the structure of regulation and the changes brought about by the new Basel III rules. These changes include higher capital requirements, new liquidity requirements, tighter capital definitions and recalibrated risk weights for assets, among many others. These changes are scheduled to be implemented around the globe between 2012 and 2019. After pinpointing the main targets of Basel regulation, the attention turns to the primary objects of regulation; capital and liquidity in banking. The study covers the basic capital structure dilemma between equity and debt, the costs and benefits of higher equity capital ratios and liquidity requirements, and provides a collation of academic estimates about an optimal capital ratio that would bring a more stable financial system without suffocating lending activity. Clearly higher levels of bank equity capital compared to Basel II-era capital requirements seem reasonable and justified according to various academic sources. The study closes with a look into the Nordic region with regards to financial stability, long run output and lending. This is achieved by mapping the evolution of capital levels among the major Nordic banks to estimates of crisis probabilities, costs and effects to lending activity. Average core capital ratios among seven major Nordic banks are found to have increased significantly, from 7,4% in 2006 to an average of 12,5% in 2011. The Swedish banking sector in particular is found to be in a robust capital condition. This increase in core capital ratios is estimated to bring a significant reduction in systemic financial crisis likelihood, to the tune of 85% less than in 2006. The less frequent financial crises are expected to result in higher long run level of GDP, but this effect is tempered by higher cost of capital and lending margins by around 25 to 125 basis points. The net effects of higher capital levels are expected to be positive however, with approximately 2% to 4% higher long run GDP level compared to what may have been expected by the capital ratios of 2006, if the Nordic financial system is considered in a closed context, and the variety of base assumptions and estimations are believed to hold.

EducationsMSc in Applied Economics and Finance, (Graduate Programme) Final Thesis
LanguageEnglish
Publication date2012
Number of pages85