The Long-term Price of Financial Reform

IMF Blog, September 11, 2012

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In response to the global crisis, policymakers 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. The authors' research strongly suggests the opposite—the reforms are well worth the money.
The 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 change 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.

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.
The authors focused on these as the reforms with the largest effect on credit pricing and note that other reforms (e.g., securitization reforms, extending the perimeter of financial regulation) will also matter but believe the combined effects studied capture the significant majority of the total impact.

Central framework: lenders must earn enough on loans to compensate for:
- the after-tax cost of the capital they put at risk;
- the rest of the funding used to make the loan;
- expected losses from borrowers who do not repay; and
- administrative expenses.
Possible offsets include excess profits on non-lending business associated with lending relationships.
Two major extensions beyond previous analyses:
- Start with the right baseline: explicitly estimate the levels of capital and liquidity that financial markets would likely have demanded absent regulatory changes, rather than attributing all post-crisis adjustments to Basel III and other regulations.
- Recognize additional adjustment channels beyond higher credit pricing or decreased availability: banks will reduce expenses over time, and investors may accept modestly lower returns because of greater safety. These offsets reduce the net cost passed to borrowers.

Base-case long-term U.S. credit price increase: 0.28 percentage points.
- Components of the U.S. net effect:
- Gross effect: 0.68 points
- Offset from lower required returns to investors: 0.20 points
- Offset from expense reductions: 0.15 points
- Offset from other actions: 0.05 points
Estimated net effects on credit pricing in other regions:
- Europe: 0.18 points
- Japan: 0.08 points

The analysis focuses on long-term effects and does not take account of transitional economic costs (for example, high short-term cost if large amounts of capital need to be raised by banks simultaneously).
The study does not reflect lingering near-term effects of the financial crisis or the current crisis in Europe, which can make credit more difficult to obtain and more expensive; these are not attributed to financial reform.
Short-run swings in credit pricing and availability may be considerably larger than the long-term results.
The authors assume financial regulations will be implemented in ways that do not unnecessarily create extra costs beyond those inherent in higher safety margins; implementation mistakes are likely to be corrected in the long run.

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.

André Oliveira Santos , Douglas J. Elliott — September 11, 2012

Staff Discussion Note
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