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André Oliveira Santos

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The Long-Term Price of Financial Reform

Posted: 09/12/2012 2:51 pm

In response to the global crisis, policymakers around the world are instituting the broadest reform of financial regulation since the Great Depression.

Some in the financial industry claim the long-run economic costs of these global reforms outweigh the benefits. But our new research strongly suggests the opposite--the reforms are well worth the money.

Granted, just as adding fenders, safety belts, airbags, and crash avoidance features can make cars slower, we know that additional safety measures can slow down the economy in years when there is no crisis. The payoff comes from averting or minimizing a disaster.

Five years after the onset of the current crisis, we sadly know all too well the cost in terms of economic growth, so the potential gains in avoiding future crises are very large.

Our study finds that the likely long-term increase in credit costs for borrowers is about one quarter of a percentage point in the United States and lower elsewhere. This is roughly the size of one small move by the Federal Reserve or other central banks. A move of that size rarely has much effect on a national economy, suggesting relatively small economic costs from these reforms.

What we looked at
How did we reach these conclusions? We examined the likely long-term impacts on credit costs from:


  • the increased capital and liquidity requirements in the new international rules known as Basel III ;

  • the major reforms in the way derivatives markets operate; and

  • higher taxes and fees to be charged to the financial industry.


We focused on these as the reforms with the largest effect on credit pricing. Other reforms will also matter, such as securitization reforms and extending the perimeter of financial regulation. We believe however that the combined effects of the reforms we studied will capture the significant majority of the total impact.

Our analytical framework
The central framework for our analysis is simple. Lenders have to earn enough on their loans to compensate for the after-tax cost of the capital they put at risk; the rest of the funding they use to make the loan; their expected losses from borrowers who do not repay; and their administrative expenses. One offset would come from excess profits on non-lending business associated with the lending relationship.

The areas of reform we studied directly affect the cost of capital, the average funding cost, and taxes. Banks can then respond to these higher costs by passing them along, accepting a lower return, or offsetting the costs by reducing expenses or taking other actions.

Our study extends previous analyses in two major ways.

First, we emphasize the importance of starting with the right baseline. Most studies have implicitly attributed all costs for the adjustments in the financial system since the crisis to Basel III and the other new financial regulations. This ignores the certainty that banks would have substantially raised their levels of capital and liquidity in response to the demands of creditors, shareholders, and other constituencies even if there were no changes to regulation. We explicitly estimate the levels that financial markets would likely have demanded on their own, and use this as the starting point to determine the additional effects from the regulatory changes.

Second, most studies over-estimate the effects of the increased safety margins by assuming the only adjustments would be through increased credit pricing or decreased availability. However, like every other industry under pressure, banks will reduce their expenses over time, in response to the squeeze on profit margins, and investors in banks will accept modestly lower returns in recognition of the greater safety of their investments in financial institutions. For example, a big trading loss or loan default has a smaller per share cost when there are more shares as a result of higher required capital levels.

Our findings
We estimate, based on a series of calculations explained in our paper that, in our base case, that long-term U.S. credit prices would rise by 0.28 percentage points. This consists of a gross effect of 0.68 points, offset by 0.20 points of benefits from lower required returns to investors, 0.15 points of expense reductions, and 0.05 points of other actions. Ignoring these offsets, as many previous analyses have done, leads to a significant overstatement of the ultimate impact on consumers and businesses. We estimate even lower net effects on credit pricing in Europe (0.18 points) and Japan (0.08 points).

It is important to note that our analysis looks at the long-term, and therefore does not take account of transitional economic costs --such as the potentially high cost if large amounts of capital need to be raised by banks simultaneously-- that may be quite significant in early years, but would be outweighed by the benefits over time.

Nor does it reflect the lingering near-term effects of the financial crisis and the impact of the current crisis in Europe, which make credit substantially more difficult to obtain and more expensive in many countries. These are not the result of financial reform. The combination of these effects may well produce short-run swings in credit pricing and availability that are considerably larger than our long-term results. We have also assumed that the financial regulations will be implemented in ways that do not unnecessarily create extra costs beyond those inherent in the higher safety margins.

In the long run, any such implementation mistakes are likely to be corrected.

Banks and other financial institutions will continue to adjust, with considerable pain, to the new reforms, but the long-term effects on borrowers and on the economy should be relatively limited compared to the large potential benefits from reducing the damage from future crises.

Written by André Oliveira Santos and Douglas J. Elliott; from iMFdirect blog

 
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