Costs and benefits of increased regulation : Empirical evidence on effects of Basel III capital ratios on Scandinavian banks

Abstract: Ever since the financial crisis, there have been calls for increased regulation of the banking industry. The Basel Accord took immediate action and introduced the third version of their Basel framework shortly after the crisis hit, increasing demands on bank capital and liquidity. The banking industry responded with a report claiming that the costs of the Basel III regulation would be high. This as banks would face increased cost of capital due to them being required to hold more expensive capital, as opposed to cheaper debt. This increase in the cost of capital would end up on the lenders bill as banks increase their lending spreads, eventually resulting in a reduction of economywide lending growth, a mechanism that later has been supported by several studies. While the theoretical impact of regulation has been widely discussed, little work has been done on an empirical level. There is thus a need for empirical evidence on what happens to banks following increased regulatory standards.Given this background, the study aims to answer the following question:“What effects have the increased capital ratios of Basel III had on Swedish, Danish and Finnish banks’ lending growth, cost of capital and default risk?”Through a quantitative study using paired T-tests as well as regression analysis, the study finds that increased capital ratios does indeed lead to lower lending growth. The extent to which is however smaller than anticipated by most other studies. Increased capital ratios were also shown to have a positive effect on banks in that it reduced their cost of capital. This shows that there are two counteracting forces on banks cost of capital following increases in capital ratios. One where cost of capital increases due to increased cost of financing, and one where cost of capital decreases as bank risk and investor expectations are lowered. The study also finds empirical evidence that the Basel risk-weighted capital ratios does not help reduce bank risk. Instead, banks reduce their risk by increasing their total capital to assets ratio. This implies that the Basel capital ratios only work through a secondary effect of banks increasing their capital to assets ratio following a regulatory tightening.The main contributions of the study are showing that regulators need to be mindful when implementing new regulation, as there are negative effects on economies lending growth. Additionally, the fact that lower bank risk results in lower cost of capital is a fact that has been mostly ignored by scholars in the field, something this study may be able to change. Lastly, the inability of the risk-based capital ratios to reduce bank risk is significant in that it puts into question whether the Basel Accord are able to produce a reliable framework for minimizing risk in the banking industry.