Increased regulation and higher capital requirements : The profitability of US banks during implementation of Basel III

Abstract: Since the financial crisis in -08 there has been a need in regulating banks and their behavior. After a while, the Basel committee took action and started to work on the third version of the Basel framework, forcing banks to maintain higher equity and to be prepared for fast drops in liquidity on the market. The banking industry quickly responded that this could create costs over the global economic market. The argument came from the idea that debt is generally cheaper to hold compared to equity. They also expected the lending growth to decrease since the economy declined, which in turn would lead to a lower net interest margin and loss of profit. There has been theory that supports their claim, but it is still lack of empirical evidence. Therefore, a need for statistical proof of what will happen to banks when regulation is increased. Based on the background, the study is aiming to answer the research question:   “What effects has the increased requirements (capital ratios, restructuring of capital) ofthe ongoing implementation ofBasel III had on US Banks’ cost of capital, lending growth and net interest margin?”   Through several regression models tested, a quantitative study was performed which found that the increased requirements of capital and capital restructuring does not affect US banks’ lending growth. Although, the capital restrains did affect banks’ cost of capital negatively as it decreased and their net interest margin as it also decreased. The cost of capital analysis showed that there must be two counteracting forces that affects the variable, where the largest one decides which way it goes. The first one is that it should increase due to more expensive financing, and the other that banks become less risky for investors to invest in. This leading to the banks’ profitability not being as threatened as one might believe.   Contributions that the study brought are showing regulators that it is a necessity to be careful when implementing new regulation, as banks might lose some of their profit from the action which could be damaging for them. It also made sure that one must not discount for the effect of reduced systematic risk, and the gain that comes from it. In the end, developing of new regulation comes down to one thing; to make our economic society safer.