Why the capital-based regulatory model for European banks leads to an impasse

After each crisis, banking regulators increase capital requirements for European banks. After the subprime crisis, it was the regulatory capital related to financial risk that was increased. Today, plans are afoot to introduce a capital requirement related to climate risk (banks will have to estimate the climate risk borne by their customers, resulting in a measure of their own climate risk). The objective of this capital- based regulation of banks is clear : it is so that European banks are able to absorb possible losses incurred on their assets with their capital, enabling their liabilities (deposits) to remain completely risk-free. But this choice of banking regulation le a d s to an impasse: Either European banks are unable to make sufficient earnings for their return on equity (RoE) to meet investors ’ requirements and what other companies offer. They are then unable to find shareholders to provide them with the necessary capital; Or the banks manage to obtain the RoE required by investors, and their cost of capital (amount of capital multiplied by the required return on capital) is very high, which makes bank intermediation expensive and uncompetitive. So a way must be found to make banks’ liabilities risk-free other than by increasing their capital requirements. Options include increase d use of securitisation or greater risk-taking by households so that they directly bear a larger share of economic risk.