In December 2009, the Basel Committee on Banking Supervision (BCBS) proposed a set of measures to strengthen global capital and liquidity regulations. The aim of these measures is to improve the resilience of the financial system. The proposed reforms will generate substantial benefits by reducing both the frequency and intensity of financial crises, thereby lowering their very large economic costs.

A key factor determining banks' responses to new capital and liquidity standards is the length of the period during which the new requirements are phased in. If the transition period is short, banks may choose to curtail credit supply in order to lift capital ratios and adjust asset composition and holdings quickly. A longer transition period could substantially mitigate the impact, allowing banks additional time to adapt by retaining earnings, issuing equity, shifting liability composition and the like. Whether the transition is long or short, decisive action to strengthen banks' capital and liquidity positions could boost confidence in the long-term stability of the financial system as soon as implementation starts. Giving banks time to use these adjustment mechanisms would almost certainly mitigate any adverse effects on lending conditions and, eventually, on aggregate activity.

Cognisant of the need to phase in the new regulations in a manner that is compatible with the ongoing economic recovery, the BCBS and the Financial Stability Board (FSB) set up a group to assess the macroeconomic effects of the transition to higher capital and liquidity requirements. This Macroeconomic Assessment Group (MAG) brings together macroeconomic modelling experts from central banks, regulatory agencies and international institutions; and is chaired by Stephen G Cecchetti, Economic Adviser of the BIS. The MAG's work is intended to complement that of the BCBS's Long-Term Economic Impact Group. Close collaboration with the IMF is an essential part of the process.

The MAG has applied common methodologies based on a set of scenarios for shifts in capital and liquidity requirements over different transition periods. These scenarios served as inputs into a broad range of models developed for policy analysis in central banks and international organisations (semi-structural large-scale models, reduced-form VAR-type models, DSGE models). Ideally, one would like these models to capture the impact of the implementation of the new standards through all relevant mechanisms - including changes in lending spreads, short-term credit supply constraints and international spillover effects - and to take into account behavioural responses from banks and other market participants as well as monetary policy responses from central banks in line with their mandates. Unfortunately, standard macroeconomic models do not readily allow for direct investigation of the effects of prudential policy changes. While different models employed by the MAG capture many of the key aspects, there is no single model that incorporates all the relevant mechanisms.

In an effort to address the problem of model incompleteness and a greater than normal level of uncertainty about model specification, the study draws on results from a diversity of models and countries. Against this background, the presentation of the results focuses on the median outcome as a central estimate of the impact across models and countries, while also showing the range of responses obtained. These results can therefore be viewed as reasonably robust estimates of the costs of transition to the stronger standards in a representative case. Continue reading