Raising capital requirements slows down economic recovery

Banks’ capital requirements have been increasing since the financial crisis. The purpose of additional capital is to increase stability by reducing lending risk. A working group appointed by the Finnish Ministry of Finance has now proposed that the authorities should have the power to raise various additional capital requirements related to systemic risks by several percentage points. It could mean a reduction of tens of billions of euros in lending capacity, which does not align with the plans to help the economy recover after the coronavirus crisis.

Companies and households that invest with borrowed money have key importance for growth and for the entire economy. There are always risks involved in lending, however, and one way for the society to manage them is to set capital requirements for banks. This capital can then be used to cover losses as they occur. Lending is supervised extensively, and reporting is required frequently and in great detail.

In the current environment, banks cannot predict when authorities are going to raise the capital requirements and by what amounts. Banks will therefore have to prepare for the worst – that is, the maximum amounts that current regulation will allow the authorities to set.

Negative surprises are known to be detrimental for taking initiative in economic activity. To foster economic growth, it is important that the combined maximum amount of additional capital requirements stays at the current level. The calculations behind the decisions should also be defined with more specificity and transparency so that banks can anticipate the decisions better.

The Finnish working group’s proposal does not sufficiently illuminate its potential effects on the economy. Raising the capital adequacy requirements by just one percentage point results in tens of billions of euros in reduced lending capacity. These amounts reduced from investments would inevitably be reflected in economic growth.

Decision-makers need to create an operating environment in which employment and investments are profitable and funding available. State aid can help SMEs and businesses with their short-term funding needs during the pandemic. This way, companies can remain healthy enough to borrow for investments, which in turn will create new business once the situation improves.

New business generates income that keeps people employed and paying taxes, and ultimately keeps the whole society running. Reducing government debt will also be easier if private investment can generate enough economic growth and prosperity.

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Financial and Prudential Regulation

Olli Salmi

Head of Banking Regulation