Transcript of a Conference Call on the Staff Discussion Note: Estimating the Costs of Financial Regulation
September 11, 2012September 11, 2012
Authors: Andre Santos and Douglas Elliott
MS. BHATT: Thanks for joining in this conference call. This is on the IMF Staff Discussion Note on Estimating the Costs of Financial Regulation.
I have with me here André Santos who’s a Senior Economist at the IMF and Douglas Elliott who’s a Fellow at the Brookings Institution, but was a consultant here at the IMF when this project was undertaken. André and Douglas will make some brief opening remarks, and then we’ll open the floor to questions and answers.
MR. SANTOS: Thank you. Good morning, ladies and gentlemen. In response to the global crisis, policymakers around the world are instituting the broadest reforms of financial regulations since the Great Depression. Some in the financial industry claim that the long-run economic costs of these global reforms outweigh the benefits, but our research strongly suggests the opposite, that the reforms are well worth the money. Granted, just as defenders of safety belts, air bags, and crash avoidance features, can make cars lower, we know that additional safety measures can slow down the economy in years when there is no crisis. Their payoff comes from averting or minimizing disaster.
Five years after the onset of the current crisis, we certainly 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 move by the fed and other central banks. A move of that size rarely has much effect on a national economy, suggesting relatively samll economic costs from these reforms.
What did we look 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 the relative markets operate; and higher tax fees to be charged to the financial industry. We focused on these as new reformswith the largest effects 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.
What is our framework? The central framework for our analysis is simple. Lenders have to earn enough on their loans to compensate for the after-tax costs of the capital they put at risk; the rest of the funds that 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 new non-lending business associated with the lending relationship. The areas of reform we studied directly affect the cost of capital, the average funding costs and taxes. Banks can respond to the higher costs by passing them along, accepting a lower return, or offsetting the costs by reducing expenses or taking other actions.
I will now turn to my colleague, Douglas Elliott.
MR. ELLIOTT: Good morning, everyone. I’m going to focus on two things: One, what’s different with our study, and then what the key findings were.
We extended the analysis of previous studies in two major ways. First, we emphasized the importance of starting with the right baseline. Most studies have implicitly attributed all costs for the adjustment 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 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 a starting point to determine the additional effects from the regulatory changes.
Second, most studies overestimate the effects of the increased safety margins by assuming the only adjustments will be through increased credit pricing or decreased availability. However, like every other industry under pressure, banks will reduce their expenses overtime in response to the squeeze on profit margins. Additionally, investors and banks will accept modestly lower returns in recognition of the greater safety of their investments in financial institutions going forward. For example, a big trading loss or a loan default has a smaller per-share cost when there are more shares as a result of higher required capital levels.
So turning to our findings: We estimate based on a series of calculations that are explained in detail in the paper that in our base case in the long term, U.S. credit prices would rise by about 0.28 percentage points, 28 basis points. This consists of a gross effect of 0.68 percentage points offset by 0.20, 20 basis points of benefits from those lower required returns that investors will demand, 15 basis points of expense reductions, and 5 basis points for some other actions that we explain. If you ignore those offsets as many previous analyses have done, it leads to a significant overstatement of the ultimate impact on consumers and businesses. Outside the U.S. we estimate that even lower net effects will occur on credit pricing, 18 basis points in Europe and 8 basis points in Japan.
It’s important to note that our analysis looks at the long term; therefore, it does not take into account transitional economic costs such as the potentially high costs if large amounts of capital need to be raised by banks simultaneously. These transitional costs could be quite significant in early years, but would be outweighed by the benefits overtime. Nor does it reflect the lingering near-term effects of the financial crisis and the impact of the current crisis in Europe, both of which make credit substantially more difficult to obtain and more expensive in many countries. We exclude them because they are not the result of financial reform. The combination of these effects, though, may well produce short-run swings in credit pricing and availability that are considerably larger than our long-term results that we found in our analysis.
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. Partly we do this because in the long run, any such implementation mistakes are likely to be corrected.
So in sum, banks and other financial institutions will continue to adjust with considerable pain to the new reforms. But we believe 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.
MS. BHATT: All right. Thank you, André and Douglas. We’ll open the floor to questions.
QUESTION: In your paper you discuss sort of the uncertainties around the liquidity rules in particular. And I’m wondering what effect could any changes -- apparently Basel members are considering changes to some of the liquidity rules -- what impact that could have on your findings?
MR. ELLIOTT: Well, certainly changes made in Basel could significantly reduce the impact. It’s really hard to know by how much without knowing the changes and having access to detailed information about the banks that, say, the European Banking Authority might have, but we do not. But since, at least in my view, the outcome of our analysis is very positive news anyway, that the costs are relatively low, this would just reinforce it if it turns out the liquidity costs are lower still.
QUESTION: I had one quick clarification question and then sort of a broader question. It says that you guys are not measuring the economic benefit of the regulations, but you do kind of I guess go from, say, suggesting that it won’t overly harm banks to not posing a big risk to the economy. So I just wanted to see if you could sort of expand and clarify on that.
And then the other question was just it seems like there’s a very different credit pricing impact for the U.S., Europe, and Japan, I guess with Japanese banks looking at only 8 basis points and the U.S. I think 26. So I just wondered if you could go into some detail on why there’s such a difference there.
MR. ELLIOTT: Okay, on the first point, you’re exactly right. We did not study in detail what the potential benefits are. That’s something I hope we can do in the future, certainly others have. But when you look at the cost levels we’ve come up with, it’s impossible not to conclude that those costs cannot possibly exceed the benefits. Again, as this rough rule of thumb we point out that one small fed move would have roughly the same effect in the U.S. as what we found. And as you just pointed out, in Japan and Europe the effects are likely to be even lower.
In terms of that point -- comparing U.S., Japan, and Europe -- the difference is principally on the effects of the capital requirements. And there the driver is that the average risk weighting for assets in Europe and Japan is roughly 40 percent, about half of the average risk weighting for U.S. assets of roughly 80 percent. And it turns out that on capital, the binding constraint, the thing that will determine how much capital needs to be raised, is the ratio of capital to risk-weighted assets. So this lower average risk weighting means that they only have to raise about half as much capital for each dollar or euro of additional assets compared to a U.S. bank
QUESTION: Do you, I mean, besides the number, are you surprised by the findings?
MR. ELLIOTT: My answer would be no. I’ve done previous work in this area and have -- and by the way, it wasn’t mentioned but I was an investment banker for about 20 years focused on the financial industry, mostly at JP Morgan. I started working on this particular area some years ago because it struck me that if you looked at the numbers, you would find relatively small effects despite concerns the industry had in the early days. So, no, I’m not personally surprised. André, do you want to add anything?
MR. SANTOS: Nor myself. I’m pretty confident in our estimates. We have been very careful, and I think they reflect our thoughts in what can happen in the future.
QUESTION: And another question, how long did you work on the study?
MR. SANTOS: Over a year.
MR. ELLIOTT: Yeah, it was over a year. It feels like about ten years at this point, but I think it was a bit over a year. And as I said, it’s built on previous work that we’ve done as well.
MS. BHATT: All right, thank you very much and thank you to André and Douglas. We now conclude this conference call.