by Don Alexander, MBA
Associate, RSD Solutions Inc.
Reforming the regulation of financial institutions and markets is critically important and should provide large benefits to society. The recent financial crisis underlined the huge economic costs produced by recessions associated with severe financial crises. However, adding safety margins and more complex financial regulations to the financial system comes at a price and can have predictable consequences. The costs of this regulatory edifice are small if it improved regulators’ ability to avert future financial crises. Financial crises can be as costly as wars and waged with the weapons of the past. The ideal for regulating a complex system is simplify the control framework and make sure the benefits of regulation outweigh the costs.
However, adding safety margins in the financial system comes at a price. Most notably, the substantially stronger capital and liquidity requirements created under the new Basel III accord have economic costs during the good years, analogous to insurance payments. There is serious disagreement about how much the additional safety margins will cost. The Institute of International Finance (IIF, 2011), bank lobbying group, project that the proposed reforms will reduce annual output in the advanced economies by approximately 3 percent by 2015. Official estimates, particularly those from the Bank for International Settlements (BIS), suggest a far smaller reduction. The recent IMF recent Staff Discussion Paper, Estimating the Cost of Financial Regulation, by Andres Santos and Douglas Elliott (September, 2012) come closer to the BIS estimates.
The IMF study shows that financial reform will likely result in a modest increase in bank lending rates in the United States, Europe, and Japan in the long term. Higher safety margins in terms of capital and liquidity will lead to an increase in lenders’ operating costs, affecting bank customers, employees, and investors. Yet banks appear to have the ability to adapt to the regulatory changes without actions that would harm the wider economy. In response to the estimated rise in regulatory costs, average bank lending rates are likely to increase by 28 bps in the United States, 17 bps in Europe, and 8 bps in Japan in the long term. By comparison, the smallest increment by which major central banks adjust their short-term policy rates is 25 bps, which tends to have a small effect on economic growth. A simple framework is used to estimate the likely increase in lending rates. These rates reflect the cost of allocated capital, other funding costs, credit losses, administrative costs, and several other factors.
There are some important limitations to the analysis presented here. Transition costs are not examined, a number of regulatory reforms are not modeled, judgment has been required in making many of the estimates, the overall modeling approach is relatively simple, and regulatory implementation is assumed to be appropriate, not creating unnecessary costs.
Financial reform comes at a price. Higher safety margins, particularly in terms of greater capital and liquidity, do add operating costs for lenders. Those costs will be passed on, at least partially, to the wider economy. There is considerable uncertainty about the true cost levels, but the sensitivity analysis demonstrates that reasonable changes in assumptions would not dramatically alter the conclusions.
The relatively low levels of economic costs found here strongly suggest that the benefits in terms of less frequent and less costly financial crisis would indeed outweigh the costs of regulatory reforms in the long run, although this study does not attempt to estimate the economic benefits of the regulatory changes. Put another way, banks around the world appear to have a considerable ability to adapt to the regulatory changes without radical actions that would harm the wider economy. The alternative outcome is a new financial crisis with severe wealth destruction, lost output and jobs.
For more on this, follow the link: www.imf.org/external/pubs/ft/sdn/2012/sdn1211.pdf
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