The Long-term Price of Financial Reform

by André Oliveira Santos and Douglas J. Elliott

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.

8 Responses

  1. Frankly, I have never heard such utter rubbish. Time the ECB, IMF, and EU got off their butts and stopped being Yes-Men for the bankers; Yes, we are 5 years on from the start of the banking mess and STILL we see the bankers are in full control; With regards to the full statement on the above, the two people who compiled this report should get their finger out of their butt and waken up.

  2. By most measures, the bailouts did stabilize the system and prevented another Great Depression (so far). I do not think any fair minded critic will disagree about that. However, there are legitimate criticisms of the societal costs of these bailouts, about the collateral damage that they wrought. We still have an ongoing propping up of banks, ZIRP, and other lingering effects.

  3. “Granted, just as adding fenders, safety belts, airbags, and crash avoidance features can make cars slower”…. How this can be? The opposite is true.

  4. The study referred to indicates: “Basel III capital requirements remain based primarily on risk-weighted assets (RWA). The key tests look at the ratio of capital to an adjusted size of total assets that reflects the presumed risk levels of the various assets.”

    And so in my opinion, the biggest failing of this study is that it only relates to sort of average interest rates and does not study how the interest rates between those perceived as “not-risky” and those perceived as “risky” evolve. In fact Basel III could even increase the regulatory discrimination against the “risky” and the regulatory favoring of the “not-risky” thereby guaranteeing that our banks could tend even more to dangerously overpopulate the safe-havens and abandon the “risky” small businesses and entrepreneurs.

  5. [...] The Long-term Price of Financial Reform – iMFdirect [...]

  6. [...] by André Oliveira Santos and Douglas J. Elliott In response to the global crisis, policymakers around the world are instituting the broadest reform of financial regulation since the Great Depression.  [...]

  7. In May 2003, as an Executive Director of the World Bank, I told regulators discussing Basel II the following:

    “There is a thesis that holds that the old agricultural traditions of burning a little each year, thereby getting rid of some of the combustible materials, was much wiser than today’s no burning at all, that only allows for the buildup of more incendiary materials, thereby guaranteeing disaster and scorched earth, when fire finally breaks out, as it does, sooner or later.

    Therefore a regulation that regulates less, but is more active and trigger-happy, and treats a bank failure as something normal, as it should be, could be a much more effective regulation. The avoidance of a crisis, by any means, might strangely lead us to the one and only bank, therefore setting us up for the mother of all moral hazards—just to proceed later to the mother of all bank crises.”

    And so, in this context, let us not forget that this mega crisis was NOT caused by lack of regulations but by bad regulations… those which for instance allowed banks to invest in AAA rated securities or lend to Greece with only 1.6 percent in capital, which signifies an authorized leverage of bank equity a mindboggling 62.5 to 1.

    But yes, we need to start to measure the full circle of life, boom and bust, and not just the cost of death.

  8. –so the potential gains in avoiding future crises are very large-

    Simply put cost/benefit analyses of the financial and banking transactions should be made on a regular basis. Both the writers have comprehensively explained the importance of financial reforms on a long term basis.

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